Budgeting Basics and Beyond

Budgeting Basics and Beyond THIRD EDITION Jae K. Shim Joel G. Siegel John Wiley & Sons, Inc. ffirs.indd iii 9/9/08 1...

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Budgeting Basics and Beyond THIRD EDITION

Jae K. Shim Joel G. Siegel

John Wiley & Sons, Inc.

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Jae K. Shim Joel G. Siegel

John Wiley & Sons, Inc.

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This book is printed on acid-free paper. Copyright © 2009 by John Wiley & Sons, Inc.. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-646-8600, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax 201-748-6008, or online at http://www.wiley .com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services, or technical support, please contact our Customer Care Department within the United States at 800-762-2974, outside the United States at 317-572-3993 or fax 317-572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our Web site at http://www.wiley.com. Library of Congress Cataloging-in-Publication Data: Shim, Jae K. Budgeting basics and beyond/Jae K. Shim, Joel G. Siegel.—3rd ed. p. cm. Includes index. ISBN 978-0-470-38968-3 (pbk.) 1. Budget in business. I. Siegel, Joel G. II. Title. HG4028.B8S558 2009 658.15'4—dc22 2008025013 Printed in the United States of America 10 9 8 7 6 5 4 3 2 1

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Contents

About the Authors Preface

vii ix

1 The What and Why of Budgeting: An Introduction

1

2 Strategic Planning and Budgeting: Process, Preparation and Control

21

3 Administering the Budget: Reports, Analyses, and Evaluations

35

4 Break-even and Contribution Margin Analysis: Profit, Cost, and Volume Changes

45

5 Profit Planning: Targeting and Reaching Achievable Goals

61

6 Master Budget: Genesis of Financial Forecasting and Profit Planning

75

7 Cost Behavior: Emphasis on Flexible Budgets

95

8 Evaluating Performance: The Use of Variance Analysis

105

9 Manufacturing Costs: Sales Forecasts and Realistic Budgets

155

10 Marketing: Budgeting for Sales, Advertising, and Distribution

167

11 Research and Development: Budgets for a Long-term Plan

185

12 General and Administrative Costs: Budgets for Maximum Productivity

197

13 Capital Expenditures: Assets to Be Bought, Sold, and Discarded

201

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Contents

14 Forecasting and Planning: Reducing Risk in Decision Making

225

15 Moving Averages and Smoothing Techniques: Quantitative Forecasting

233

16 Regression Analysis: Popular Sales Forecast System

243

17 Cash Budgeting and Forecasting Cash Flow: Two Pragmatic Methods

253

18 Financial Modeling: Tools for Budgeting and Profit Planning

265

19 Software Packages: Computer-based Models and Spreadsheet Software

277

20 Capital Budgeting: Selecting the Optimum Long-term Investment

289

21 Zero-base Budgeting: Priority Budgeting for Best Resource Allocation

321

22 Managers’ Performance and Balanced Scorecard: Evaluation on the Division Level

329

23 Budgeting for Service Organizations: Special Features

359

24 Budgeting for Nonprofit Organizations: Diverse Types

367

25 Using Management Games for Executive Training

387

Appendix I

Present and Future Value Tables

405

Appendix II

Statistical Table

411

Glossary of Budgeting and Planning Terms

413

Index

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About the Authors

J

AE K. SHIM is a professor of accounting and finance at California State University, Long Beach and CEO of Delta Consulting Company, a financial consulting and training firm. Dr. Shim received his M.B.A. and Ph.D. degrees from the University of California at Berkeley (Haas School of Business). Dr. Shim has been a consultant to commercial and nonprofit organizations for over 30 years. Dr. Shim has over 50 college and professional books to his credit, including, Managerial Accounting, Barron’s Accounting Handbook, Barron’s Dictionary of Accounting Terms, 2009 GAAP, Encyclopedic Dictionary of Accounting and Finance, 2008–2009 Corporate Controller’s Handbook of Financial Management, U.S. Master Finance Guide, Dictionary of Personal Finance, Investment Sourcebook, Dictionary of Real Estate, Dictionary of International Investment Terms, Dictionary of Business Terms, The Vest-Pocket CPA, The Vest-Pocket CFO, and the best-selling Vest-Pocket MBA. Twenty-six of his publications have been translated into foreign languages such as Chinese, Spanish, Russian, Polish, Croatian, Italian, Japanese, and Korean. Professor Shim’s books have been published by Thompson-Southwestern, John Wiley, McGraw-Hill, Barron’s, Commercial Clearing House (CCH), PrenticeHall, American Management Association (Amacom), and the American Institute of CPAs (AICPA). Dr. Shim has been frequently quoted by such media as the Los Angeles Times, Orange County Register, Business Start-ups, Personal Finance, and Money Radio. Dr. Shim has also published numerous articles in professional and academic journals. He was the recipient of the Financial Management Association International’s 1982 Credit Research Foundation Award for his article on cash flow forecasting and financial modeling. Joel G. Siegel, Ph.D., CPA, is a financial consultant and professor of accounting and finance at Queens College of the City University of New York. He was previously employed by Coopers and Lybrand, CPAs, and Arthur Andersen, CPAs. Dr. Siegel has acted as a consultant to many organizations including Citicorp, International Telephone and Telegraph, United Technologies, American Institute of CPAs, and Person-Wolinsky Associates. Dr. Siegel is the author of 67 books and about 300 articles on accounting and financial topics. His books have been published by Prentice Hall, McGraw-Hill, vii

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About the Authors

Harper Collins, John Wiley & Sons, Inc., Macmillan, International Publishing, Barron’s, Southwestern, Aspen, Richard Irwin, Probus, American Management Association, and the American Institute of CPAs. Dr. Siegel’s articles have been published in many accounting and financial journals including Financial Executive, The Financial Analysts Journal, The CPA Journal, Practical Accountant, and the National Public Accountant. In 1972, he was the recipient of the Outstanding Educator of America Award. Dr. Siegel is listed in Who’s Where Among Writers and Who’s Who in the World. His international reputation led to his appointment in 1992 as chairperson of the National Oversight Board.

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Preface

B

etter budgets can boost your department and your career to higher levels of performance and success. Savvy executives use the budgeting process to take stock of their direction, refine their goals, and share their mission with their staff. Their budgeting reveals their position in the market, places untapped resources at their command, and motivates all employees to greater levels of productivity. They use their budgets to propel them towards the top of their industry. This book will show you how to get there. Budgeting Basics and Beyond shows you how the budget can be your most powerful tool for strategy and communications. It points out that the budget brings into stark relief all of the factors that every manager must consider, such as industry conditions, competition, degree of risk, stability of operations, capacity limitations, pricing policies, turnover rates in assets, production conditions, product line and service considerations, inventory balances and condition, trends in the marketplace, number of employees and their technical abilities, availability and cost of raw materials, available physical resources, technological considerations, economy, and political aspects. Then it uncovers the role each of those factors plays in achieving your corporate goals. And since those goals cannot be achieved single-handedly, this book suggests ways to use the budget to help each employee appreciate how they will contribute to the division’s profitability. Aside from playing a vital role in creating and achieving a sound business strategy, this book shows how budgets can increase your effectiveness every day of the week. In particular, it delivers these on-the-job budgeting tools: ■ ■

■ ■ ■ ■ ■

Techniques for preparing more accurate, realistic, and reliable estimates Control and variance analysis devices that signal revenue, cost, and operations thresholds Pricing guidelines for products and services Planning and scheduling production and related costs Profit planning and identifying looming problems Financial models that show the relationship among all facets of the business Spreadsheet applications for planning, budgeting, and control purposes

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Implication of active financial planning software Sales and financial forecasting methodology Balanced Scorecard and performance metrics

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Preface

We follow the example of each of these tools with examples of how you can use them to make a difference in your work right away. And we use step-by-step guidelines to pinpoint what to look for, what to watch for, what to do, how to do it, and how to apply it on the job. Through step-by-step illustration, we show how you can put these tools to use. We hope that you will keep Budgeting Basics and Beyond handy for easy, quick reference and daily use.

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1 The What and Why of Budgeting An Introduction

A

budget is defined as the formal expression of plans, goals, and objectives of management that covers all aspects of operations for a designated time period. The budget is a tool providing targets and direction. Budgets provide control over the immediate environment, help to master the financial aspects of the job and department, and solve problems before they occur. Budgets focus on the importance of evaluating alternative actions before decisions actually are implemented. A budget is a financial plan to control future operations and results. It is expressed in numbers, such as dollars, units, pounds, hours, manpower, and so on. It is needed to operate effectively and efficiently. Budgeting, when used effectively, is a technique resulting in systematic, productive management. Budgeting facilitates control and communication and also provides motivation to employees. Budgeting allocates funds to achieve desired outcomes. A budget may span any period of time. It may be short term (one year or less, which is usually the case), intermediate term (two to three years), or long term (three years or more). Shortterm budgets provide greater detail and specifics. Intermediate budgets examine the projects the company currently is undertaking and start the programs necessary to achieve long-term objectives. Long-term plans are very broad and may be translated into short-term plans. The budget period varies according to its objectives, use, and the dependability of the data used to prepare it. The budget period is contingent on business risk, sales and operating stability, production methods, and length of the processing cycle. There is a definite relationship between long-range planning and short-term business plans. The ability to meet near-term budget goals will move the business in the direction of accomplishing long-term objectives. Budgeting is done for the company as a whole, as well as for its component segments including divisions, departments, products, projects, services, manpower, and geographic areas. 1

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Budgeting Basics and Beyond

Budgets aid decision making, measurement, and coordination of the efforts of the various groups within the entity. Budgets highlight the interaction of each business segment to the whole organization. For example, budgets are prepared for units within a department, such as product lines; for the department itself; for the division, which consists of a number of departments; and for the company. Master (comprehensive) budgeting is a complete expression of the planning operations of the company for a specific period. It is involved with both manufacturing and nonmanufacturing activities. Budgets should set priorities within the organization. They may be in the form of a plan, project, or strategy. Budgets consider external factors, such as market trends, economic conditions, and the like. The budget should list assumptions, targeted objectives, and agenda before number crunching begins. The first step in creating a budget is to determine the overall or strategic goals and strategies of the business, which are then translated into specific long-term goals, annual budgets, and operating plans. Corporate goals include earnings growth, cost minimization, sales, production volume, return on investment, and product or service quality. The budget requires the analysis and study of historical information, current trends, and industry norms. Budgets may be prepared of expected revenue, costs, profits, cash flow, production purchases, net worth, and so on. Budgets should be prepared for all major areas of the business. The techniques and details of preparing, reviewing, and approving budgets varies among companies. The process should be tailored to each entity’s individual needs. Five important areas in budgeting are planning, coordinating, directing, analyzing, and controlling. The longer the budgeting period, the less reliable are the estimates. Budgets link the nonfinancial plans and controls that constitute daily managerial operations with the corresponding plans and controls designed to accomplish satisfactory earnings and financial position. Effective budgeting requires the existence of: ■ ■ ■ ■ ■

Predictive ability Clear channels of communication, authority, and responsibility Accounting-generated accurate, reliable, and timely information Compatibility and understandability of information Support at all levels of the organization: upper, middle, and lower

The budget should be reviewed by a group so that there is a broad knowledge base. Budget figures should be honest to ensure trust between the parties. At the corporate level, the budget examines sales and production to estimate corporate earnings and cash flow. At the department level, the budget examines the effect of work output on costs. A departmental budget shows resources available, when and how they will be used, and expected accomplishments. Budgets are useful tools in allocating resources (e.g., machinery, employees), making staff changes, scheduling production, and operating the business. Budgets

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The What and Why of Budgeting

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3

help keep expenditures within defined limits. Consideration should be given to alternative methods of operations. Budgets are by departments and responsibility centers. They should reflect the goals and objectives of each department through all levels of the organization. Budgeting aids all departmental areas including management, marketing, personnel, engineering, production, distribution, and facilities. In budgeting, consideration should be given to the company’s manpower and production scheduling, labor relations, pricing, resources, new product introduction and development, raw material cycles, technological trends, inventory levels, turnover rate, product or service obsolescence, reliability of input data, stability of market or industry, seasonality, financing needs, and marketing and advertising. Consideration should also be given to the economy, politics, competition, changing consumer base and taste, and market share. Budgets should be understandable and attainable. Flexibility and innovation is needed to allow for unexpected contingencies. Flexibility is aided by variable budgets, supplemental budgets, authorized variances, and review and revision. Budgets should be computerized to aid “what-if” analysis. Budgeting enhances flexibility through the planning process because alternative courses of action are considered in advance rather than forcing less-informed decisions to be made on the spot. As one factor changes, other factors within the budget will also change. Internal factors are controllable by the company whereas external factors usually cannot be controlled. Internal factors include risk and product innovation. Forecasting is predicting the outcome of events. It is an essential starting point for budgeting. Budgeting is planning for a result and controlling to accomplish that result. Budgeting is a tool, and its success depends on the effectiveness to which it is used by staff. In a recessionary environment, proper budgeting can increase the survival rate. A company may fail from sloppy or incomplete budgeting. Exhibit 1.1 shows a graphic depiction of budget segments. We now consider planning, types of budgets, the budgetary process, budget coordination, departmental budgeting, comparing actual to budgeted figures, budget revision and weaknesses, control and audit, participative budgeting, and the pros and the cons of budgets.

Planning Budgeting is a planning and control system. It communicates to all members of the organization what is expected of them. Planning is determining the activities to be accomplished to achieve objectives and goals. Planning is needed so that a company can operate its departments and segments successfully. It looks at what should be done, how it should be done, when it should be done, and by whom. Planning involves the determination of objectives, evaluating alternative courses of action, and authorization to select programs. There should be a good interface of segments within the organization. Budgets are blueprints for projected action and a formalization of the planning process. Plans are expressed in quantitative and monetary terms. Planning is

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Exhibit 1.1 Budget Segments President

Vice President of Finance

Vice President of Manufacturing

Vice President of Marketing

Controller

Director of Manufacturing

Director of Sales

Investment Centers

Profit Centers

Revenue Centers

Cost Centers

taking an action based on investigation, analysis, and research. Potential problems are searched out. Budgeting induces planning in each phase of the company’s operation. A profit plan is what a company expects to follow to attain a profit goal. Managers should be discouraged from spending their entire budget. Managers should be given credit for cost savings. Budget planning meetings should be held routinely to discuss such topics as the number of staff needed, objectives, resources, and time schedules. There should be clear communication of how the numbers are established and why, what assumptions were made, and what the objectives are.

Types of Budgets It is necessary to be familiar with the various types of budgets to understand the whole picture and how these budgets interrelate. The types of budgets include master, operating (for income statement items comprised of revenue and expenses), financial (for balance sheet items), cash, static (fixed), flexible, capital expenditure (facilities), and program (appropriations for specific activities such as research and development, and advertising). These budgets are briefly explained below.

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Master Budget A master budget is an overall financial and operating plan for a forthcoming calendar or fiscal year. It is usually prepared annually or quarterly. The master budget is really a number of subbudgets tied together to summarize the planned activities of the business. The format of the master budget depends on the size and nature of the business. Operating and Financial Budgets The operating budget deals with the costs for merchandise or services produced. The financial budget examines the expected assets, liabilities, and stockholders’ equity of the business. It is needed to see the company’s financial health. Cash Budget The cash budget is for cash planning and control. It presents expected cash inflow and outflow for a designated time period. The cash budget helps management keep cash balances in reasonable relationship to its needs and aids in avoiding idle cash and possible cash shortages. The cash budget typically consists of four major sections: 1. Receipts section, which is the beginning cash balance, cash collections from customers, and other receipts 2. Disbursement section, comprised of all cash payments made by purpose 3. Cash surplus or deficit section, showing the difference between cash receipts and cash payments 4. Financing section, providing a detailed account of the borrowings and repayments expected during the period Static (Fixed) Budget The static (fixed) budget is budgeted figures at the expected capacity level. Allowances are set forth for specific purposes with monetary limitations. It is used when a company is relatively stable. Stability usually refers to sales. The problem with a static budget is that it lacks the flexibility to adjust to unpredictable changes. In industry, fixed budgets are appropriate for those departments whose workload does not have a direct current relationship to sales, production, or some other volume determinant related to the department’s operations. The work of the departments is determined by management decision rather than by sales volume. Most administrative, general marketing, and even manufacturing management departments are in this category. Fixed appropriations for specific projects or programs not necessarily completed in the fiscal period also become fixed budgets to the extent that they will be expended during the year. Examples are appropriations for

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capital expenditures, major repair projects, and specific advertising or promotional programs. Flexible (Expense) Budget The flexible (expense) budget is most commonly used by companies. It allows for variability in the business and for unexpected changes. It is dynamic in nature rather than static. Flexible budgets adjust budget allowances to the actual activity. Flexible budgets are effective when volumes vary within a relatively narrow range. They are easy to prepare with computerized spreadsheets such as Excel. The four basic steps in preparing a flexible (expense) budget are: 1. Determine the relevant range over which activity is expected to fluctuate during the coming period. 2. Analyze costs that will be incurred over the relevant range in terms of determining cost behavior patterns (variable, fixed, or mixed). 3. Separate costs by behavior, determining the formula for variable and mixed costs. 4. Using the formula for the variable portion of the costs, prepare a budget showing what costs will be incurred at various points throughout the relevant range. Due to uncertainties inherent in planning, three forecasts may be projected: one at an optimistic level, one at a pessimistic or extremely conservative level, and one at a balanced, in-between level. Capital Expenditure Budget The capital expenditure budget is a listing of important long-term projects to be undertaken and capital (fixed assets such as plant and equipment) to be acquired. The estimated cost of the project and the timing of the capital expenditures are enumerated along with how the capital assets are to be financed. The budgeting period is typically for 3 to 10 years. A capital projects committee, which is typically separate from the budget committee, may be created solely for capital budgeting purposes. The capital expenditures budget often classifies individual projects by objective, as for ■ ■ ■ ■

Expansion and enhancement of existing product lines Cost reduction and replacement Development of new products Health and safety expenditures

The lack of funds may prevent attractive potential projects from being approved.

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An approval of a capital project typically means approval of the project in principle. However, final approval is not automatic. To obtain final approval, a special authorization request is prepared for the project, spelling out the proposal in more detail. The authorization requests may be approved at various managerial levels depending on their nature and dollar magnitude.

Program Budget Programming is deciding on the programs to be funded and by how much. A common application of program budgets is to product lines. Resources are allocated to accomplish a specific objective with a review of existing and new programs. Some suitable program activities include research and development, marketing, training, preventive maintenance, engineering, and public relations. Funds usually are allocated based on cost effectiveness. In budget negotiations, proposed budgetary figures should be explained and justified. The program budget typically cannot be used for control purposes because the costs shown cannot ordinarily be related to the responsibilities of specific individuals. Depending on needs and convenience, budgets can be classified as incremental, add-on, supplemental, bracket, stretch, strategic, activity-based, target, and/or continuous.

Incremental Budget Incremental budgeting looks at the increase in the budget in terms of dollars or percentages without considering the whole accumulated body of the budget. There are also self-contained, self-justified increments of projects. Each one specifies resource utilization and expected benefits. A project may be segregated into one or more increments. Additional increments are required to complete the project. Manpower and resources are assigned to each increment.

Add-on Budget An add-on budget is one in which previous years’ budgets are examined and adjusted for current information, such as inflation and employee raises. Money is added to the budget to satisfy the new requirements. With add-on, there is no incentive for efficiency, but competition forces one to look for new, better ways of doing things. For example, Konica Imaging U.S.A. has combined add-on with zero-based review.

Supplemental Budget Supplemental budgets provide additional funding for an area not included in the regular budget.

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Bracket Budget A bracket budget is a contingency plan where costs are projected at higher and lower levels than the base amount. Sales are then forecasted for these levels. The purpose of this method is that if the base budget and the resulting sales forecast is not achieved, the bracket budget provides management with a sense of earnings impact and a contingency expense plan. A contingency budget may be appropriate when there are downside risks that should be planned for, such as a sharp drop in revenue. Stretch Budget A stretch budget may be considered a contingency budget on the optimistic side. Typically it is only confined to sales and marketing projections that are higher than estimates. It is rarely applied to expenses. Stretch targets may be held informally without making operating units accountable for them. Alternatively, stretch targets may be official estimates for sales/marketing personnel. Expenses may be estimated at the standard budget sales target. Strategic Budget Strategic budgeting integrates strategic planning and budgeting control. It is effective under conditions of uncertainty and instability. Activity-based Budget Activity-based budgeting budgets costs for individual activities. Target Budget A target budget is a plan in which categories of major expenditures are matched to company goals. The emphasis is on formulating methods of project funding to move the company forward. There must be strict justification for large dollars and special project requests. Continuous (Rolling) Budget A continuous (rolling) budget is one that is revised on a regular (continuous) basis. Typically, a company extends such a budget for another month or quarter in accordance with new data as the current month or quarter ends. For example, if the budget is for 12 months, a budget for the next 12 months will be available continuously as each month ends. Note: Fixed budgets are criticized as being ineffective in a rapidly changing world. Companies report performance on a calendar basis, but floods, stock market crashes, strikes, and a competitor ’s new product

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announcement, happen continuously. In consequence, some leading companies have abandoned fixed budgets and changed to rolling forecasts to inspire and lead their companies to better performance. Rolling forecasts direct management’s attention towards the future, and ensure that planning is ongoing, as opposed to an annual exercise.

Budgetary Process A sound budget process communicates organizational goals, allocates resources, provides feedback, and motivates employees. The budgetary process should be standardized by using budget manuals, budget forms, and formal procedures. Software, Program Evaluation and Review Technique (PERT), and Gantt facilitate the budgeting process and preparation. The timetable for the budget must be kept. If the budget is a “rush job,” unrealistic targets may be set. The budget process used by a company should suit its needs, be consistent with its organizational structure, and take into account human resources. The budgetary process establishes goals and policies, formulates limits, enumerates resource needs, examines specific requirements, provides flexibility, incorporates assumptions, and considers constraints. The budgeting process should take into account a careful analysis of the current status of the company. The process takes longer as the complexity of the operations increase. A budget is based on past experience plus a change in light of the current environment. The six steps in the budgeting process are: 1. 2. 3. 4. 5. 6.

Setting objectives Analyzing available resources Negotiating to estimate budget components Coordinating and reviewing components Obtaining final approval Distributing the approved budget

A budget committee should review budget estimates from each segment, make recommendations, revise budgeted figures as needed, and approve or disapprove of the budget. The committee should be available for advice if a problem arises in gathering financial data. The committee can also reconcile diverse interests of budget preparers and users. The success of the budgeting process requires the cooperation of all levels within the organization. For example, without top management or operating management support, the budget will fail. Those involved in budgeting must be properly trained and guided in the objectives, benefits, steps, and procedures. There should be adequate supervision. The preparation of a comprehensive budget usually begins with the anticipated volume of sales or services, which is a crucial factor that determines the level of activity for a period. In other cases, factory capacity, the supply of labor, or the

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availability of raw materials could be the limiting factor to sales. After sales are forecast, production costs and operating expenses can be estimated. The budgeting period varies with the type of business, but it should be long enough to include complete cycles of season, production, inventory turnover, and financial activities. Other considerations are product or service to be rendered and regulatory requirements. The budget guidelines prepared by top management are passed down through successive levels in the company. Managers at each level may make additions and provide greater detail for subordinates. The managers at each level prepare the plans for items under their control. For example, Philip Morris formulates departmental budgets for each functional area. The budgeting process will forewarn management of possible problems that may arise. By knowing the problems, solutions may be formulated. For example, at the valleys in cash flow, a shortage of cash may occur. By knowing this in advance, management may arrange for a short-term loan for the financing need rather than face a sudden financing crisis. In a similar vein, planning allows for a smooth manufacturing schedule to result in both lower production costs and lower inventory levels. It avoids a crisis situation requiring overtime or high transportation charges to receive supplies ordered on a rush basis. Without proper planning, cyclical product demand needs may arise, straining resources and capacity. Resources include material, labor, and storage.

Bottom-up Versus Top-down A budget plans for future business actions. Managers prefer a participative bottom-up approach to an authoritative top-down approach. The bottom-up method begins at the bottom or operating (departmental) level based on the objectives of the segment. However, operating levels must satisfy the overall company goals. Each department prepares its own budget (such as estimates of component activities and product lines by department) before it is integrated into the master budget. Managers are more motivated to achieve budgeted goals when they are involved in budget preparation. A broad level of participation usually leads to greater support for the budget and the entity as a whole, as well as greater understanding of what is to be accomplished. Advantages of a participative budget include greater accuracy of budget estimates. Managers with immediate operational responsibility for activities have a better understanding of what results can be achieved and at what costs. Also, managers cannot blame unrealistic goals as an excuse for not achieving budget expectations when they have helped to establish those goals. Despite the involvement of lower-level managers, top management still must participate in the budget process to ensure that the combined goals of the various departments are consistent with profitability objectives of the company. The goals may include growth rates, manpower needs, minimum return on investment, and pricing. In effect, departmental budgets are used to determine the organizational budget. The budget is reviewed, adjusted if necessary, and approved

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at each higher level. The bottom-up approach would forecast sales by product or other category, then by company sales, and then by market share. The bottom-up method may be used to increase the feeling of unit-level ownership in the budget. Disadvantages are the time-consuming process from participative input and the fact that operating units may neglect some company objectives. Bottom-up does not allow for control of the process, and the resulting budget is likely to be unbalanced with regard to the relationship of expenses to revenue. Typical questions to answer when preparing a bottom-up budget are: What are the expected promotional and travel expenses for the coming period? What staff requirements will be needed? What are the expected raises for the coming year? What quantity of supplies will be needed? This approach is particularly necessary when responsibility unit managers are expected to be very innovative. Unit managers know what must be achieved, where the opportunities are, what problem areas must be resolved, and where resources must be allocated. In the top-down approach, a central corporate staff under the chief executive officer or president determines overall company objectives and strategies, enumerates resource constraints, considers competition, prepares the budget, and makes allocations. Management considers the competitive and economic environment. Top management knows the company’s objectives, strategies, resources, strengths, and weaknesses. Departmental objectives follow from the action plans. Top-down is commonly used in long-range planning. A top-down approach is needed for a company having significant interdependence among operating units to enhance coordination. The top-down approach first would forecast sales based on an examination of the economy, then the company’s share of the market and the company’s sales, and then sales by products or other category. A top-down approach may be needed when business unit managers must be given specific performance objectives due to a crisis situation and when close coordination is required between business units. It is possible that the sum of the unit budgets would not meet corporate expectations. If unit managers develop budgets independently of other units, there are inconsistencies in the assumptions used by different units. A disadvantage with this approach is that central staff may not have all the knowledge needed to prepare the budget within every segment of the organization. Managers at the operating levels are more knowledgeable and familiar with the segment’s operations. Managers will not support or commit to a budget they were not involved in preparing, which will cause a motivational problem. Further, the top-down approach stifles creativity. A budget needs input from affected managers, but top management knows the overall picture. A combination of the bottom-up and top-down approaches may be appropriate in certain cases. Some large companies may integrate the methods. For example, Konica Imaging uses whichever method fits best. The company uses a blend. Direction is supplied from the top, and senior management develops action plans. Each department must then determine how it will actually implement the plan, specifically looking at the resources and expenditures required. This is

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the quantification of the action plans into dollars. It is then reviewed to see if it achieves the desired results. If it does not, it will be kicked back until it is brought in line with the desired outcomes. The what, why, and when is specified from the top, and the how and who is specified from the bottom. As an example of the budgeting process, Power Cord and Cable Corporation (PCCC) uses a comprehensive or master budget to summarize the objective of all its subunits such as Sales, Production, Marketing, Administrative, Purchasing and Finance. Like all organizations, PCCC uses a master budget as a blueprint for planned operations in a particular time period.

Budget Coordination There should be one person responsible for centralized control over the budget who must work closely with general management and department heads. A budget is a quantitative plan of action that aids in coordination and implementation. The budget communicates objectives to all the departments within the company. The budget presents upper management with coordinated and summarized data as to the financial ramifications of plans and actions of various departments and units within the company. Budgets usually are established for all departments and major segments in the company. The budget must be comprehensive, including all interrelated departments. The budget process should receive input from all departments so there is coordination within the firm. For example, operations will improve when marketing, purchasing, personnel, and finance departments cooperate. Coordination involves obtaining and organizing the needed personnel, equipment, and materials to carry out the business. A budget aids in coordination between separate activity units to ensure that all parts of the company are in balance with each other and know how they fit in. It discloses weaknesses in the organizational structure. The budget communicates to staff what is expected of them. It allows for a consensus of ideas, strategies, and direction. The interdependencies between departments and activities must be considered in a budget. For example, the sales manager depends on sufficient units produced in the production department. Production depends on how many units can be sold. Most budget components are affected by other components. For example, most components are impacted by expected sales volume and inventory levels, while purchases are based on expected production and raw material inventories. A budget allows for directing and control. Directing means supervising the activities to ensure they are carried out in an effective and efficient manner within time and cost constraints. Controlling involves measuring the progress of resources and personnel to accomplish a desired objective. A comparison is made between actual results and budgeting estimates to identify problems needing attention. In summation, the budget must consider the requirements of each department or function and the relationship that departments or functions have with other departments and functions. Activities and resources have to be coordinated.

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Departmental Budgeting All department managers within a company must accurately determine their future costs and must plan activities to accomplish corporate objectives. Departmental supervisors must have a significant input into budgeting costs and revenues because these people are directly involved with the activity and have the best knowledge of it. Managers must examine whether their budgetary assumptions and estimates are reasonable. Budget targets should match manager responsibilities. At the departmental level, the budget considers the expected work output and translates it into estimated future costs. Budgets are needed for each department. The sales department must forecast future sales volume of each product or service as well as the selling price. It probably will budget revenue by sales territory and customer. It will also budget costs such as wages, promotion and entertainment, and travel. The production department must estimate future costs to produce the product or service and the cost per unit. The production manager may have to budget work during the manufacturing activity so the work flow continues smoothly. The purchasing department will budget units and dollar purchases. There may be a breakdown by supplier. There will be a cost budget for salaries, supplies, rent, and so on. The stores department will budget its costs for holding inventory. There may be a breakdown of products into categories. The finance department must estimate how much money will be received and where it will be spent to determine cash adequacy. An illustrative budget showing revenue and expense by product line appears in Exhibit 1.2.

Actual Costs Versus Budget Costs A budget provides an early warning of impending problems. The effectiveness of a budget depends on how sound and accurate the estimates are. The planning must take all factors into account in a realistic way. The budget figures may be inaccurate because of such factors as economic problems, political unrest, competitive shifts in the industry, introduction of new products, and regulatory changes. At the beginning of the period, the budget is a plan. At the end of the period, the budget is a control instrument to assist management in measuring its performance against the plan so as to improve future performance. Budgeted revenue and costs are compared to actual revenue and costs to determine variances. A determination has to be made whether the variances are controllable or uncontrollable. If controllable, the parties responsible must be identified. Action must be taken to correct any problems. A comparison should be made between actual costs at actual activity to budgeted costs at actual activity. In this way, there is a common base of comparison. The percentage and dollar difference between the budget and actual figures should be shown. A typical performance report for a division appears in Exhibit 1.3. Authorized variances in cost budgets allow for an increase in the initial budget for unfavorable variances. This increase may result from unexpected wage

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Net income

Less: Taxes

Income before taxes

Total

Other indirect costs

Fixed overhead

Continuing costs

Contribution margin

Variable costs

Semi-direct distribution

Fixed

Variable

Direct distribution costs

Manufacturing contribution margin

Less: Variable cost of sales

Net revenue

Less: Sales returns and allowances

Gross revenue

Description

Amount

Percentage of Net Sales

All Products X Amount


Y Amount


Product Line

Statement of Revenue and Expense by Product for the Year Ended 20X2

Exhibit 1.2

Z Amount



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Exhibit 1.3 XYZ Company Divisional Performance Evaluation December 31, 20X2

Division

Actual

Expected

Over (Under) Plan

A B C Total

$ 2,000 3,000 5,000 $10,000

$ 4,000 5,000 6,000 $15,000

($2,000) (2,000) (1,000) ($5,000)

Net Income

Actual

Expected

Over (Under) Plan

$1,000 700 600 $2,300

$ 800 600 1,000 $2,400

$200 100 (400) ($100)

Net Sales

increases, prices of raw materials, and so on. Allowance is given for cost excesses that a manager can justify.

Budget Revision A budget should be monitored regularly. A budget should be revised to make it accurate during the period because of error, feedback, new data, changing conditions (e.g., economic, political, corporate), or modification of the company’s plan. Human error is more likely when the budget is large and complex. A change in conditions typically will affect the sales forecast and resulting cost estimates. Revisions are more common in volatile industries. The budget revision applies to the remainder of the accounting period. A company may “roll a budget,” which is continuous budgeting for an additional incremental period at the end of the reporting period. The new period is added to the remaining periods to form the new budget. Continuous budgets reinforce constant planning, consider past information, and take into account emerging conditions.

Budget Weaknesses The signs of budget weaknesses must be spotted so that corrective action may be taken. Such signs include: ■ ■ ■

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Managerial goals are off target or unrealistic. There is management indecisiveness. The budget takes too long to prepare.

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■ ■ ■ ■

■

■

■

■

■

■

■


Budget preparers are unfamiliar with the operations being budgeted and do not seek such information. Budget preparers should visit the actual operations firsthand. Budget preparers do not keep current. The budget is prepared using different methods each year. There is a lack of raw information going into the budgeting process. There is a lack of communication between those involved in budgeting and operating personnel. The budget is formulated without input from those affected by it. This will likely result in budgeting errors. Further, budget preparers do not go into the operations field. Managers do not know how their budget allowances have been assigned or what the components of their charges are. If managers do not understand the information, they will not perform their functions properly. The budget document is excessively long, confusing, or filled with unnecessary information. There may be inadequate narrative data to explain the numbers. Managers are ignoring their budgets because they appear unusable and unrealistic. Managers feel they are not getting anything out of the budget process. Changes are made to the budget too frequently. Significant unfavorable variances are not investigated and corrected. These variances may also not be considered in deriving budgeted figures for next period. Further, a large variance between actual and budgeted figures, either positive or negative, that repeatedly occurs is an indicator of poor budgeting. Perhaps the budgeted figures were unrealistic. Another problem is that after variances are identified, it is too late to correct their causes. Further, variance reporting may be too infrequent. There is a mismatching of products or services.

Budgetary Control and Audit As discussed previously, the budget is a major control device for revenue, costs, and operations. The purpose is to increase profitability and reduce costs, or to meet other corporate objectives as quickly as possible. Budgetary control may also be related to nonfinancial activities, such as the life cycle of the product or seasonality. An illustrative budget control report is shown in Exhibit 1.4. A budget audit should be undertaken to determine the correctness of the budgeted figures. Was there a proper evaluation of costs? Were all costs included that should have been? What are the cost trends? Are budgeted figures too tight or too loose? Are budgeted figures properly supported by documentation? A budget audit appraises budgeting techniques, procedures, manager attitudes, and effectiveness. The major aspects of the budgeting process have to be examined. Exhibit 1.5 depicts the control process in budgeting.

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Exhibit 1.4 Budget Control Report I.

Budget Savings One-year Savings Amount: Two- to Five-Year Savings Amount: More Than Five-Year Savings Amount: Savings Description:

II.

Budget impact Reduction in Current Year Budget Budget Account Budget Amount Budget Adjustment Not Needed

III.

Budget Participants Management: Employees:

IV. V.

Names: Names:

Job Description: Job Description:

Management Incentives: Employee Awards

Prepared By: Reviewed By: Approved By:

Computer Applications A computer should be used to make quick and accurate calculations, keep track of projects instantly, and make proper comparisons. With the use of a spreadsheet program, budgeting can be an effective tool to evaluate “what-if” scenarios. This way the manager should be able to move toward finding the best course of action among various alternatives through simulation. If the manager does not like the result, he or she may alter the contemplated decision and planning set. Specialized software that is solely devoted to budget preparation and analysis also exists.

Motivation Budgets can be used to affect employee attitudes and performance. Budgets should be participative, including participation by those to be affected by them. Further, lower-level employees are on the operating line every day so they are quite knowledgeable. Their input is needed. Budgets can be used to motivate because

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Exhibit 1.5 Budgeting Control Process Analysis of Information, Assumptions, and Different Scenarios Selection Budget Reports

Budget Reports

Plan

Operational Functions

Feedback

Study and Evaluation

Good Performance?

Yes

No

Retain As Is

Remedial Steps

participants will internalize the budget goals as their own since they participated in their development. Information should be interchanged among budget participants. An imposed budget will have a negative effect on motivation. Further, there is a correlation between task difficulty and loss of control to negative attitudes. A budget is a motivational and challenging tool if it is tight but attainable. It has to be realistic. If the budget is too tight, it results in frustration because managers will give up and not try to achieve the unrealistic targets. If it is too loose, complacency will arise and workers may goof off. The best way to set budget targets is with a probability of achievement by most managers 80 to 90 percent of the time. Performance above the target level should be supplemented with incentives including bonuses, promotion, and additional responsibility.

Advantages and Disadvantages of Budgets Budgeting involves cost and time to prepare. The benefits of budgeting must outweigh the drawbacks. A budget can be advantageous because it: ■ ■

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Links objectives and resources. Communicates to managers what is expected of them. Any problems in communication and working relationships are identified. Resources and requirements are identified.

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The What and Why of Budgeting ■ ■

■

■ ■

■ ■

■

■

■

■

■

■ ■

■ ■ ■

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Establishes guidelines in the form of a road map to proceed in the right direction. Improves managerial decision making because emphasis is on future events and associated opportunities. Encourages delegation of responsibility and enables managers to focus more on the specifics of their plans and how realistic the plans are, and how such plans may be effectively achieved. Provides an accurate analytical technique. Provides better management of subordinates. For example, a manager can use the budget to encourage salespeople to consider their clientele in long-term strategic terms. Fosters careful study before making decisions. Helps management become aware of the problems faced by lower levels within the organization. It promotes labor relations. Allows for thinking how to make operations and resources more productive, efficient, competitive, and profitable. It leads to cost reduction. Allows management to monitor, control, and direct activities within the company. Performance standards act as incentives to perform more effectively. Points out deviations between budget and actual, resulting in warning signals for changes or alterations. Helps identify, on a timely basis, weaknesses in the organizational structure. There is early notice of dangers or departures from forecasts. The formulation and administration of budgets pinpoints communication weaknesses, assigns responsibility, and improves working relationships. Provides management with foresight into potential crisis situations so alternative plans may be instituted. Provides early signals of upcoming threats and opportunities. Aids coordination between departments to attain efficiency and productivity. There is an interlocking within the business organization. For example, the production department will manufacture based on the sales department’s anticipated sales volume. The purchasing department will buy raw materials based on the production department’s expected production volume. The personnel department will hire or lay off workers based on anticipated production levels. Executives are forced to consider relationships among individual operations and the company as a whole. Provides a motivational device setting a standard for employees to achieve. Provides measures of self-evaluation. Management can make distasteful decisions and blame it on the budget. A budget can be disadvantageous because:

■

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A budget promotes gamesmanship in that those managers who significantly inflate requests, knowing they will be reduced, are in effect rewarded by getting what they probably really wanted.

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■ ■

■


A budget may reward managers who set modest goals and penalize those who set ambitious goals that are missed. There is judgment and subjectivity in the budgeting process. Managers may consider that budgets redirect their flexibility to adjust to changing conditions. A budget does not consider quality and customer service.

Conclusion A budget should be based on norms and standards. The budget should be coordinated, integrated, organized, systematic, clear, and comprehensive to accomplish optimal results. The budget preparation, review, and evaluation process must be facilitated. An orderly budgeting process will result in less cost, less man-hours, and minimization of conflict and turmoil. It will require less revision at a later date. The budget process must consider input-output relationships. The budget aids in anticipating problems before they become critical. Short-term budgets should be used for businesses subject to rapid change. A budget is a tool for planning and for “what-if” analysis. It aids in identifying the best course of action. As it is in the computer world—garbage in, garbage out—so it is with budgeting. If forecasts are inaccurate so will be the projections, resulting in bad management decisions to the detriment of the firm. A manager must be cautious when analyzing past experience. Unforeseen circumstances such as economic downturns and future innovations have direct inputs on current operations. A manager deviating from a budget target must explain why and, of course, is on the defensive. Without proper justification for missing targets, the manager may be dismissed. The failure to budget may result in conflicting and contradictory plans as well as in wasting corporate resources. Budget slack should be avoided or minimized. Budget slack is the underestimation of revenues and the overestimation of expenses. Budgets should be revised as circumstances materially change. A manager who has responsibility to meet a budget should also have the authorization to use corporate resources to accomplish that budget. Priorities should be established for the allocation of scarce resources. Budgets may include supplementary information such as break-even analysis by department, by product, and for overall operations. It is important to avoid the situation in which a manager feels he or she must spend the entire budget or else lose funding in the next period. Managers should not be motivated to spend the entire budget. Rather, cost savings should be realized, and those responsible should be recognized, such as through cash bonuses or nonmonetary awards (e.g., trophy, medals). Budget savers should be protected in the funding for future budgets. Budgets should not be arbitrarily cut across the board. Doing so may result in disastrous consequences in certain programs. If budget reductions are necessary, determine exactly where and by how much.

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2 Strategic Planning and Budgeting Process, Preparation, and Control

A

lthough it differs among companies, planning is the direction of the company over a period of time to accomplish a desired result. Planning should link short-term, intermediate-term, and long-term goals. The objective is to make the best use of the company’s available resources over the long term. Budgeting is simply one portion of the plan. The annual plan may be based on the long-term plan. The annual budget should be consistent with the long-term goals of the business. There should be a climate conducive to planning and friendly relationships. An objective of planning is to improve profitability. Plans are interrelated. In planning, management selects long-term and short-term goals and draws up plans to accomplish those goals. Planning is more important in long-run management. The objectives of a plan must be continually appraised in terms of degree of accomplishment and how long it takes to implement. There should be feedback as to the plan’s progress. It is best to concentrate on accomplishing fewer targets so proper attention will be given to them. Objectives must be specific and measurable. For example, a target to increase sales by 20 percent is definite and specific. The manager can measure quantitatively the progress toward meeting this target. The plan is the set of details implementing the strategy. The plan of execution typically is explained in sequential steps including costs and timing for each step. Deadlines are set. The planning function includes all managerial activities that ultimately enable an organization to achieve its goals. Because every organization needs to set and achieve goals, planning often is called the first function of management. At the highest levels of business, planning involves establishing company strategies, that is, determining how the resources of the business will be used to reach its objective. Planning also involves the establishment of policies—the day-to-day guidelines used by managers to accomplish their objectives. The elements of a plan 21

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include objectives, performance standards, appraisal of performance, action plan, and financial figures. All management levels should be involved in preparing budgets. There should be a budget for each responsibility center. Responsibility in particular areas should be assigned for planning to specific personnel. At Adolph Coors Company, planning is ongoing, encouraging managers to assume active roles in the organization. A plan is a predetermined action course. Planning has to consider the organizational structure, taking into account authority and responsibility. Planning is determining what should be done, how it should be done, and when it should be done. The plan should specify the nature of the problems, reasons for them, constraints, contents, characteristics, category, alternative ways of accomplishing objectives, and listing of information required. Planning objectives include quantity and quality of products and services as well as growth opportunities. A plan is a detailed outline of activities to meet desired strategies to accomplish goals. Such goals must be realistic. Planning requires analysis of the situation. The plan should specify the evaluative criteria and measurement methods. The assumptions of a plan must be specified and appraised as to whether they are reasonable. The financial effects of alternative strategies should be noted. Planning should allow for creativity. Planning involves analyzing the strengths and weaknesses of the company and each segment therein. Planning is needed to allocate various resources to organizational units and programs. Long-term plans should consider new opportunities, competition, resources (equipment, machinery, manpower), diversification, expansion, financial strength, and flexibility. In planning, consideration has to be given to noncyclical occurrences, such as new product or service introduction, modification in manufacturing processes, and discontinuance of a product or service. Strategic budgeting is a form of long-range planning based on identifying and specifying organizational goals and objectives. The strengths and weaknesses of the organization are evaluated, and risk levels are assessed. The influences of environmental factors are forecast to derive the best strategy for reaching the organization’s objectives. Several planning assumptions should be made at the beginning of the budget process. Some of these assumptions are internal factors; others are external to the company. External factors include general economic conditions and their expected trend, governmental regulatory measures, the labor market in the locale of the company’s facilities, and activities of competitors, including the effects of mergers. Planning is facilitated when the business is stable. For example, a company with a few products or services operating in stable markets can plan better than one with many diverse products operating in volatile markets. Planning should take into account industry and competing company conditions. A description of products, facilities, resources, and markets should be noted in the plan. The emphasis should be on better use of resources, including physical facilities and personnel. In summation, a plan is a detailed outline of activities and strategies to satisfy a long-term objective. An objective is a quantifiable target. The objective is derived from an evaluation of the situation. A diagram of the strategic planning process appears in Exhibit 2.1.

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Strategic Planning and Budgeting

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Exhibit 2.1 Strategic Planning Process Evaluate Industry and Company Conditions

Ascertain Mission of Company Strategic Planning

Reject

Accept Select Long-term Corporate Objectives

Reject

Accept Formulate Strategies to Meet Objectives

Reject

Accept Prepare Long-term Plan

Reject

Accept

Long-term Planning

Compare Performance Against Plan

Appraise Feedback

Budgeting Budgeting is a form of planning and policy development considering resource constraints. It is a profit planning mechanism and may look at “what-if” scenarios. Budgets are detailed and communicate to subunits what is expected of them. Those responsible for expenditures and revenue should provide budget information. Planning should be by the smallest practical segment. Budgeting is worthwhile if its use makes the company more profitable than without it. Budgets are quantitative expressions of the yearly profit plan and measure progress during the period. The shorter the budgeting period, the more reliable. A cumulative budget may drop the prior month and add the next month. Probabilities may be used in budgeting. Of course, the total probabilities must add up to 100%.

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Example 1 The sales manager assigns these probabilities to expected sales for the year: Probability

Expected Sales

Probable Sales

50% 30% 20% 100%

$3,000,000 2,000,000 4,000,000

$1,500,000 600,000 800,000 2,900,000

The probabilities are based on the manager ’s best judgment. The probabilities may be expressed in either quantitative (percentages) or relative terms (high or low probability of something happening). A typical department budget appears in Exhibit 2.2. A typical checklist for the budgeting system appears in Exhibit 2.3.

Strategic Planning Strategic plans are long-term, broad plans ranging from 2 to 30 years, with 5 to 10 years being most typical. Strategic planning is continuous and looks where the company is going. It is done by upper management and divisional managers. Most of the information used is external to the company. The strategic plan is the mission of the company and looks to existing and prospective products and markets. Strategic plans are designed to direct the company’s activities, priorities, and goals. They try to position the company so as to accomplish opportunities. Strategic goals are for the long term, considering the internal and external environment, strengths, and weaknesses. Strategy is the means by which the company uses its capital, financial, and human resources to achieve its objectives. It shows the company’s future direction and rationale, and looks at expected costs and return. Strategic planning is detailed plans to implement policies and strategies. Risk-taking decisions are made. Strategies may be implemented at different times. Strategic planning should take into account the financial position, economy, political environment, social trends, technology, risks, markets, competition, product line, customer base, research support, manufacturing capabilities, manpower, product life cycle, and major problems. Strategic planning is a prerequisite to short-term planning. There should be a linkage of the two. There is considerably more subjectivity in a strategic plan than in a short-term plan. The strategic plan is formulated by the chief executive officer (CEO) and his or her staff. It considers acquisitions and divestitures. Financial policies, including debt position, are determined. The plan must consider economic, competitive, and industry factors. It establishes direction, priorities, alternatives, and tasks to be performed. The strategic plan is the guideline for each business segment and the needed activities to accomplish the common goals. Strategic planning is irregular. Further, strategic planning problems are unstructured. If a strategy becomes unworkable, abandon it.

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25

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Direct Labor 1 2 3 4 5 Total Direct Labor Indirect Labor Indirect Salaries Supervisor Salaries Cleaning Holidays and Vacations Idle Time Other Salaries Subtotal Other Department Costs Operating Supplies Tools Telephone Travel Consultants Memberships Misc. Department Expenses Subtotal Total Department Expenses

Classification

Budget

Actual

Dollar Amount Current Month

Cumulative to Date

Over or Under

Department ____________________________________________ Department Administrator ____________________________________________

XYZ Company Department Budget Report

Exhibit 2.2

Percent Realized Current Month

Prior

Moving Average Current

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Exhibit 2.3 A Budgetary Checklist Schedule

Who Is Accountable?

Date Required

Date Received

1. Establish overall goals 2. Set division and department objectives 3. Estimate a. Capital resource needs b. Personnel requirements c. Sales to customers d. Financial status 4. Preparation of budgets for: a. Profitability b. Revenue c. Production Direct material Direct labor Factory overhead d. Marketing budget Advertising and promotion Sales personnel and administration Distribution Service and parts e. Cash budget f. Budgeted balance sheet g. Capital facilities budget h. Research and development budget 5. Prepare individual budgets and the master budget 6. Review budgets and prepare required changes 7. Prepare monthly performance reports 8. Determine difference between budget and actual costs (revenue) 9. Prepare recommendations to improve future performance

The elements of a strategic plan are: ■

■

■ ■

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The company’s overall objectives, such as market position, product leadership, and employee development The strategies necessary to achieve the objectives, such as engaging in a new promotion plan, enhancing research, product and geographical diversification, and eliminating a division The goals to be met under the strategy The progress to date of accomplishing the goals; examples of goals are sales, profitability, return on investment, and market price of stock

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27

In summation, strategic planning is planning for the company as a whole, not just combining the separate plans of the respective parts. There must be a common thread. The strategic plans look to the long term. It is concerned with the few key decisions that determine the company’s success or failure. It provides overall direction and indicates how the long-term goals will be achieved. It is a mission policy statement and must deal with critical issues.

Short-term Plans Short-range plans are typically for one year (although some plans are for two years). The plans examine expected earnings, cash flow, and capital expenditures. Short-term plans may be for a period within one year, such as a month or week. Short-term planning relies primarily on internal information and details tactical objectives. It is structured, fixed, foreseeable, and continually determinable. The short-term profit plan is based on the strategic plan. It is concerned with existing products and markets. There should be a short-term profit plan by area of responsibility (product, service, territory, division, department, project, function, and activity). Shortterm plans usually are expressed on a departmental basis. They include sales, manufacturing, marketing, management (administration), research, and consolidation (integration) plans. Short-term planning has more lower-level managers involved in providing input. The line manager typically is involved with shortterm rather than long-term plans. In making the short-term plan, the line manager should consider the company’s objectives and targets outlined in its long-term plan. The manager ’s short-term plan must satisfy the long-term objectives of the company.

Long-term Plans Long-term planning is usually of a broad, strategic (tactical) nature to accomplish objectives. A long-term plan is typically 5 to 10 years (or more) and looks at the future direction of the company. It also considers economic, political, and industry conditions. Long-term plans are formulated by upper management. They deal with products, markets, services, and operations. Long-range planning enhances sales, profitability, return on investment, and growth. Long-range plans should be constantly revised as new information becomes available. Long-range planning covers all major areas of the business including manufacturing, marketing, research, finance, engineering, law, accounting, and personnel. Planning for these areas should be coordinated into a comprehensive plan to attain corporate objectives. A long-term plan is a combination of the operating and developmental plans. The long-term plan should specify what is needed, by whom, and when. Responsibility should be assigned to segments. Long-term goals include market share, new markets, expansion, new distribution channels, cost reduction, capital maintenance,

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and reduction of risk. The characteristics of sound long-term objectives include flexibility, motivation, measurability, consistency and compatibility, adequateness, and flexibility. Long-range plans may be used for growth, market share, product development, plant expansion, and financing. Long-range plans are details of accomplishing the strategic plans. Compared to strategic planning, long-range planning is closer to planning current operations of all units of the business. Long-range planning includes evaluating alternatives, developing financial information, analyzing activities, allocating resources, product planning, market analysis, planning manpower, analyzing finances, research and development planning, and production planning. The time period for a long-term plan depends on the time required for product development, product life cycle, market development, and construction of capital facilities. More alternatives are available in long-term plans than in short-term plans. When there is greater uncertainty in the economic and business environment, long-range plans become more important. However, it is more difficult to plan long term than short term because of the greater uncertainties that exist. An illustrative long-term plan appears in Exhibit 2.4.

Time Period The budget period depends on the objective of the budget and the reliability of the data. Most companies budget yearly, month by month. For example, a seasonal business should use the natural business year beginning when accounts receivable and inventory are at their lowest level. The time period for a plan should be as far as is useful. The period chosen depends on many factors: the time to develop a market; production period; the time

Exhibit 2.4 Long-term Plan Amount Contract acquisitions

—Customer —Division —Company

Sales backlog

—Customer —Division —Company

Total sales Profit margin Return on investment Capital expenditures

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—Assets —Leases

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29

to develop raw material sources and to construct capital facilities; product development; and product life cycle. The time period also should take into account the type of industry, reliability of financial data and use to which the data will be put, seasonality, and inventory turnover. Shorter budgeting cycles may be called for when unpredictable and unstable events occur during the year. Short-term budgets have considerably more detail than long-term budgets.

Administering the Plan A committee of senior operating and financial executives should be involved in administering a budget. The administration plan consists of human resource planning for the various functions to be carried out, technological resource planning, and organizational planning.

Profit Plan A profit plan is the premise on which management charts an action course for the upcoming year. It is good for planning and control. Alternatives must be evaluated, and the profit plan should be flexible to adjust for contingencies. Profit planning includes a study of appraising profits relative to investment. A profit budget may be used to supplement a cost budget. Profit budgets may be by customer, territory, or product. The profit plan must set forth selling price, sales volume, sales mix, per-unit cost, competition, advertising, research, market potential, and economic conditions. Profit may be improved through a closer correlation of manufacturing, selling, and administrative expense budgeting to sales and earnings objectives. Cost reduction programs will lower expenses. Continuous profit planning is used when planning should be for short time periods and where frequent planning is needed. The yearly or quarterly plan may be revised each month.

Operational Plan The preliminary operational plan is an important part of the strategic plan. It examines the alternative strategies so as to select the best one. The final operational plan is much more detailed and is the basis to prepare the annual budgets and to evaluate performance. It also acts as the basis to integrate and communicate business functions. It is concerned with short-term activity or functions of the business. The operational plan typically includes production, marketing (selling), administration, and finance. It examines properly serving product or service markets. The operational plan summarizes the major action programs and contains this information: objective, program description, responsibility assignments, resource

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needs (e.g., assets, employees), expected costs, time deadlines for each stage, input needed from other business segments, and anticipated results.

Development Plan The development plan typically includes research and development, diversification, and divestment. It relates to developing future products, services, or markets. The development plan mostly applies to new markets and products. Bonuses should be given for new ideas. The corporate development plan is concerned with: ■ ■ ■

■

Discovering or creating new products Identifying financially lucrative areas and those having growth potential Ascertaining what resources are required in terms of assets, manpower, and so on Determining the feasibility of expanding operations into new areas

Contingency Planning Contingency planning is anticipating in advance unexpected circumstances, occurrences, and situations so that there can be a fast response to a crisis. All possible eventualities should be considered. Contingency planning involves identifying the possible occurrence, ascertaining warning signs and indicators of a problem, and formulating a response. Contingency planning can be in the form of flexible (bracket) budgets. The plan should be modified if needed to generate the best results. There should be flexibility in the plan to adjust to new information and circumstances and to allow for the resolution of uncertainties.

Activity Budget An activity budget is a revised analysis of a budget showing expenses at budgeted rates adjusted to actual production volume.

Budget Process In one company we are familiar with, the Financial Planning Department issues guidelines to department managers. The manager then submits his or her plan to Financial Planning. The plan is returned to the manager if guidelines have not been adhered to. Financial Planning coordinates the plan from the bottom up. The budget goes down to the supervisory level. The company also uses program budgeting, which involves the allocation of resources. The budgeting process requires good, timely communication. Upper management must make its budget goals

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clear to departmental managers. In turn, the managers must explain departmental operating conditions and limitations.

Departmental Budgets The decision units in the plan must be identified, and the manpower and dollar support at each decision unit must be noted. Department managers should plan for specific activities. They should put their budgets and trends in perspective relative to other departments in the company, to competing departments in other companies, and to industry norms. The manager should list the problems needing solution or the opportunities to be further capitalized on.

Budget Accuracy The accuracy of budget preparation may be determined by comparing actual numbers to budget numbers in terms of dollars and units. Budget accuracy is higher when the two figures are closer to each other. Ratios showing budget accuracy include: Sales Accuracy ⫽ Actual Sales/Budgeted Sales Cost Accuracy ⫽ Actual Cost/Budgeted Cost Profit Accuracy ⫽ Actual Profit/Budgeted Profit Example 2 A manager budgeted sales for 2 million but the actual sales were 2.5 million. This favorable development might be attributed to one or more of these reasons: ■

■

■

Deficient planning because past and current information were not properly considered when the budget was prepared The intentional understatement of expected sales so the manager would look like a hero when actual sales substantially exceeded the anticipated sales Higher revenue arising from better economic conditions, new product lines, improved sales promotion, excellent salesperson performance, or other reasons

A significant deviation between budget and actual amounts may indicate poor planning. Is the planning unrealistic, optimistic, or due to incompetent performance? However, the problem may be with wasteful spending or inefficient operations.

Reports A typical report for manufacturing cost analysis is presented in Exhibit 2.5. Performance reports typically are issued monthly.

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Product Line

Units Produced

Material

Labor

Variable

Fixed

Overhead

Manufacturing Cost Analysis

Exhibit 2.5

Total Cost

Unit Cost

Selling Price

Average Gross Margin


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Budget Revision A budget should be revised when it no longer acts as a useful planning and control device. Budgets should be revised when a major change in processes or operations occur, or when there are significant changes in salary rates. For example, additional competitors may enter the market with a product that sells at a lower price and is a good substitute for the company’s product. This competition may make meeting the budgeted market share and sales unlikely. If management recognizes that even with increased promotional expenditures, budgeted sales are not realistic, all budgets affected should be revised. These revisions are preferable to using unattainable budgets. Budgets that are repeatedly revised are more informative as a control measure. For a one-year budget, budget estimates may be revised quarterly. Budget revisions should be more frequent in unstable businesses.

Performance Measures Performance measures also should be directed at the lower levels. Specific task performance for each employee should be measured. Employee performance may be measured by computing revenue per employee, man-hours per employee, and production volume to man-hours.

Control and Analysis Control is important in budgeting. Budget figures may be checked for reasonableness by looking at relationships. The budgeted costs must be directly tied to planned production output. The manager must be able to strongly defend the initial budget figure and to obtain needed facts. Budget comparisons may be made by current year month to last year month, current year quarter to last year quarter, and cumulative year to date. A comparison is therefore made to similar time periods. Costs should be examined by responsibility. Cost reduction is different from cost control. Cost reduction attempts to lower costs by improving manufacturing methods and procedures, work assignments, and product or service quality. Cost control includes cost reduction. Cost control attempts to obtain cost objectives within the operational setting. Value analysis is an evaluation of cost components in an operation so as to minimize them to achieve higher profits. Compare the company’s segments to similar segments in competing companies. Variations from the plan should be studied and controlled. The integrated (consolidated) plan usually is prepared yearly. A change in one department’s plan will likely affect another department’s plan.

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3 Administering the Budget Reports, Analyses, and Evaluations

A

budget should be prepared for each department. Divisional budgets should be consolidated in a binder, and each department should have a separate file folder. The chief executive officer should distribute an executive budget memorandum to each department manager detailing the schedule, policies, and benchmarks for next year ’s budget. Responsibility should be assigned for collection and consolidation of budget information. Budget instructions, forms, and timetables should be provided. Budget forms should be simple and easy to follow. The budget committee should consider these items before approving a budget: accuracy of budgetary numbers, reliability of information on which estimates are based, budget integration, reliability of source data, budgetary assumptions, and achievability of budgetary goals.

Types of Reports Long-term reports may be for the company as a whole or for specific areas. The benefit derived from reports should justify their cost. Budget reports are used for planning, control, and information. Planning reports may be short term, looking at the company as a whole, each division, each department, and each responsibility center within the department. Short-term planning reports may be of income, cash flow, net assets, and capital expenditures. The reports should be prepared regularly. Special studies may be performed of “problem” segments not performing well. The special studies may be of product or service lines, activities or functions, geographic areas, salesperson performance, and warehousing. Control reports concentrate on performance effectiveness and areas needing improvement. Budget to actual figures are compared by product, service, territory, and manpower.

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Information reports assist in planning and policy formulation. The reports show areas of growth or contraction. They may be in dollars, units, percentages, or ratios. Trends are shown over time. An example of an informative ratio is selling expense to revenue. Informational reports study the trend in earnings, profit by product or service, profit by territory, and profit by customer. Reports for upper management are comprehensive summaries of overall corporate operations. Top management generally prefers narrative reports. Reports are also prepared for special events of concern to top management. Adequate detail should be provided as needed. Middle-management reports include summarized information and detailed information on daily operations. A brief report should be presented at budget meetings. Lower-level management reports typically deal with daily coordination and control operations. The reports usually emphasize production. Exception reports should be prepared indicating problems. Budget reports inform managers of progress made in meeting budgets and what went wrong, if anything. A critical area should be reported on more frequently. The frequency of reporting is less as the level of responsibility becomes higher. Budget reports depend on the requirements of the situation and user. Budget reports should contain these data: ■ ■ ■

Trends over the years Comparison to industry norms Comparison of actual to budget with explanation and responsible party for variances. Follow-up procedures are needed for control

Reports should get to the main points. Each report should begin with a summary followed by detailed information and should be comprehensible to those using it. The emphasis should be on clarity rather than complexity. Reports should be logically organized, relevant, and concise. Reports should be updated on a periodic basis. Reports may contain schedules, explanations, graphs, and tables. Reports should contain recommendations and highlight problem areas. All reports should be computerized. An illustrative budget worksheet appears in Exhibit 3.1. Reports may be periodic, advance, or special.

Periodic Reports These are reports prepared at regular intervals. There is a continual comparison between budget and actual figures. They are the usual source of information to maintain control. They may be issued semiannually, quarterly, monthly, and so on. Monthly reports are most common. Some information may be reported daily (e.g., shipments), while other information may be reported weekly (e.g., sales and production). The timeliness depends on cost/benefit analysis.

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Administering the Budget

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Exhibit 3.1 Budget Worksheet Account: For the period: Date: Month

Components

Explanation: Assumptions: Analysis:

Advance Reports Important partial information may be reported before all information is available for a periodic report. Delay in reporting this information will cause a managerial problem. “Flash reports” should be issued for unusual occurrences that must be reported on immediately. Special Studies Special reports are issued for a specific, nonroutine purpose. Special studies may be required for problem situations or if a negative trend exists, such as costs keep rising even though a cost reduction program has been implemented. Budget reports may contain this supplementary information depending on need: ■ ■ ■ ■ ■ ■ ■

■

Percent of capacity utilization Changes in marketing and distribution Change in selling price Average selling price Sales volume and units produced Distribution cost relative to sales Effect on sales of new product introduction, dropping products, and entering new product lines Change in the number of employees and man-hours

A performance report should be prepared for each responsibility center, going from the lowest level to the highest level. The report indicates whether goals

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have been accomplished. Performance reports evaluate efficiency, and should be repetitive, covering a short time period. The performance-to-budget report should contain this information by department for year-to-date and for current period: ■ ■ ■ ■

Cost accounts Budget Actual Variances and reasons

An illustrative report summarizing departmental performance is shown in Exhibit 3.2. A performance-to-budget report (cost and variance statement) should be kept for feedback. It is used by management to evaluate the degree to which operating managers meet their budget. Monthly performance reports should contain variances for the month and cumulative variances to date for the year. Variances can be expressed in dollars and as a percentage of budget. The statistics and graphics in the report should vary depending on user preference. For example, marketing managers are less inclined to receive statistical data than engineers. However, marketing managers prefer graphs. Graphs may be more informative in presenting relationships and summary comparisons. Graphs include diagrams and charts. Reports should be timely. If reports are issued periodically, they should be on schedule. If reports must be delayed, a short update should be presented.

Exhibit 3.2 Summary of Department Performance Item and Explanation

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Actual

Budget

Percent of Budget

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Budget Manual A budget manual describes how a budget is to be prepared. Items usually included in a budget manual are a planning calendar and distribution instructions for all budget schedules. Distribution instructions are important because, once a schedule is prepared, other departments within the organization will use the schedule to prepare their own budgets. Without distribution instructions, someone who needs a particular schedule may be overlooked. The budget manual communicates throughout the company the policies and procedures for budget preparation. It lists the activities and rules to be followed in preparing a budget. It tells how the budget should be used by managers and who is responsible for the different aspects of the budgeting process, including preparation, presentation, reporting, evaluation, and approval. It should list positions rather than names to avoid unnecessary updating. A flow chart for budget preparation would be helpful. It provides the budgeting steps and aids in cooperation and coordination. The procedures to be followed to revise the budget based on changing conditions and goals should be specified. For example, revisions may be needed because of changing objectives, new methods, changing economic environment, and errors. The budget manual should receive participation from all affected managerial levels. The budget manual stipulates authority, responsibility, and duties; fosters standardization; documents procedures; simplifies the process; provides communication; answers users’ questions; enhances supervision; and fosters training. The manual includes: ■ ■ ■ ■ ■

Standardized forms, lists, and reports Instructions Format and coverage of performance reports Administrative details Follow-up procedures

Each department should be included in a separate section of the manual with an index tab. Operating department managers and employees should provide input in the preparation of the budget manual. Managers and workers may have different information to impart. There may be operating problems, constraints, and limitations that must receive attention. There should be a standard cost table for different types of expenses used by managers of different departments throughout the organization. This allows for consistency and uniformity. The manual should be in loose-leaf form so pages may be substituted for updates. The budget manual should contain: ■ ■ ■

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Budget objectives, purposes, procedures, guidelines, and policy Desired accomplishments Data description

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40 ■ ■

■ ■

■ ■ ■ ■ ■ ■ ■ ■ ■

/


Personnel duties (who is to prepare, review, approve, and revise the budget) Who has authority and responsibility for budget items (with a designation of manager or subordinate who will perform the activity) Approval requirements Who is to evaluate the difference between budget and actual figures, and who is to take corrective action and when Budget timetable Illustrative forms, lists, and reports Glossary of terminology Instructions to complete budget activities Uses of budget information Policies for budget modification and update calendar Communication between upper management and subordinates Coordination between departments of the budget Explanatory footnotes

The layout of the manual should enhance its clarity and conciseness. It should be easy to understand for nonaccountants, so it should not contain complex or technical language. It should be arranged logically and orderly with a user-friendly index and should be updated as conditions warrant. It should look professional in design, color, print size, and so on, so it is taken seriously by users. Having a budget manual offers many advantages, including simplification and standardization of budget procedures. It acts as a reference and provides an organized approach to the budget process. It provides consistency between departments, provides job description guidance to new employees, and assists current employees to adjust to new positions when transferred or promoted. The manual helps employee continuity in doing the job.

Budget Sheet A budget sheet should be designed to record the information used by the operating manager and budget preparer. The budgeting sheet should include this information: ■ ■ ■ ■

Historical cost records used Cost formulas Changes in operating conditions Foreseeable conditions

A budget data sheet should be prepared for each cost account in each department or cost center. Attached to the data sheet may be graphs, workpaper analysis, mathematical and statistical calculations, and so on. Budget revisions may also be incorporated.

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Exhibit 3.3 Budget Data sheet Date prepared: Date accepted: Date approved: Date revised: Cost center identifier Account identifier Activity unit Amount and reason for revision Items

Total

Time period:

Fixed

Variable

Mixed (Semivariable)

Total Budget

Fixed, variable, and mixed costs are shown on the data sheet. Material, labor, and overhead should be listed. The sheets should be initialed by those preparing and approving them. The allowances specified in the data sheet should be mutually agreed on by the preparer and operating manager. A typical budget data sheet is shown in Exhibit 3.3. A budget summary sheet also should be prepared summarizing the department’s budget by listing each budgeted cost and the budget allowance based on average activity. The summary sheet summarizes the departmental budget data sheets. The operating departmental manager always should be provided with a copy of the budget summary sheet and budget data sheets. A budget data book should be maintained to keep the budgeting information in an orderly manner. The book contains the budget data sheets, supporting worksheets and analysis, and budget summary sheets by department.

Performance Reports The manager should prepare performance reports. Are objectives and targets being met by subordinates? Are operations being performed efficiently and effectively? The performance-to-budget report should include this information by department for month and year-to-date: budget, actual, and variance. Variances may be stated in dollars and percentage terms. An illustrative performance-to-budget report is presented in Exhibit 3.4.

Budget Audit A budget audit examines whether the budgeting process is operating effectively. It is an evaluation of the budgeting effort. The budget audit examines techniques,

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Exhibit 3.4 Performance-to-Budget Report Department Identifier __________________ Activity Nonfinancial Manager _________________ Budget Actual Percent of Budget This Period Year-toDate Budget

Actual

Variance

Budget

Actual

Variance

Cause of Variance

Extra Budgetary Allowance for Variance

Totals

procedures, motivation, and budget effectiveness. Effective budgeting should be dynamic. A budget audit detects problems in the budgeting process. It should be conducted every two to three years by an independent party not a part of the budget staff. The budget auditor should report to upper management, who can take appropriate action. An outside consultant should be independent and objective, and should provide fresh ideas. An audit plan assists in arriving at corrective action. The budget audit considers: ■ ■ ■ ■ ■ ■ ■ ■ ■

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Cost trends and controls Budget revisions How adequately costs were analyzed How costs were identified and classified Looseness or tightness of budget allowances Completeness of budget documentation, records, and schedules Degree of participation by managers and workers Quality of supportive data Degree of subjectivity involved

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Budget Calendar The budget planning calendar is the schedule of activities for the development and adoption of the budget. It should include a list of dates indicating when specific information is to be provided by each information source to others. A budget calendar should be prepared for the timing of each aspect or operation of the budget. A timetable must be given to operating managers to submit their proposed budgets so the overall company budget may be prepared on time. The schedule of due dates for documents and reports must be adhered to. Review and approval dates should also be specified. The schedule dates should be realistic and attainable. A company can begin the process by issuing a budget preparation calendar, which consists of an overall review of each sequential step in the budgeting process. Accompanying this is a rough time schedule in which the budgeting process will be implemented identifying deadlines, the personnel responsible, and those to receive this information. The plan furnishes the structure of the budgeting process and the overall objectives. These items are crucial for the budgeting process and must be completed before the process can proceed. An illustrative budget calendar for a company is presented in Exhibit 3.5. Exhibit 3.5 ABC Company Budget Preparation Calendar Fiscal 20X8 1. General Guidelines issued to senior management staff by president gives the broad objectives of the company for the ensuing year. These objectives must be specific enough to provide divisions with adequate direction, yet they should be broad enough so as not to prevent creativity. General indication of gross margins, operating profit, net profit, and productivity are some of the areas to be addressed. 2. New Products Forecast will provide an indication of new/improved products to be available next year. This will include estimated availability dates and likely segment as applicable. 3. Discussion of Action Plans with particular emphasis on how to achieve objectives (on individual basis) with senior management by president. Each senior vice president will produce in writing and justify in detail how he or she will achieve the objectives for next year. For example, Sales and Marketing should give expected sales by regions supported by level of sales force and related promotional expenses (advertising/conventions and product giveaway). (a) Headcount by department/division to support objectives must be justified by each senior vice president. (b) C.E. Projections outline the major projects to be executed in the budget year as determined by the department managers and facilities engineering. Projects should be ranked in order of priority with pros and cons of doing and not doing the projects. (c) Inventory Projections as furnished by vice president of respective user department (Film, Chemistry, and Equipment) should indicate the levels of the inventory by major product lines. Where applicable, a minimum, desired, and maximum levels to support production and sales should be given. 4. Fringe Benefits Package including payroll increase prepared by the Human Resources Department should outline the basis of the company’s contribution of the major programs and fringes. Both quantitative and qualitative factors should be presented. Major areas

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Exhibit 3.5

(continued )

to be covered are incentives, medical, dental, retirement, life insurance and workmen’s compensation. Other expenditures such as FICA and unemployment tax will be computed by Corporate Planning. 5. Budget Package issued to departmental managers by Corporate Planning contains the necessary forms and instructions to prepare the Budget. 6. Preliminary Profit & Loss (P&L) Fiscal 20X8 based on sales forecast and assumptions in 2–4 will be prepared by Corporate Planning. This will give an indication of the likely outcome of the actions contemplated. Major directions and proactive measures will then be taken to manage the budget process in line with the president’s guidelines. 7. Final Sales Forecast as issued to senior management staff by Sales/Marketing would give sales volume and dollars by major product lines. For example, film and paper (sq. ft. & $), chemistry (quantity & S) and equipment (unit & $). Film and paper should be analyzed by region, international, dealers, national accounts, and others. New products should be clearly identified. Adequate explanation should be given for any significant changes (over the current year) in volume or price. 8. Departmental Expense Budgets are prepared (monthly basis) by department managers and approved by their respective senior management. These include all the operating expenses (excluding payroll, fringes, depreciation and facilities cost) as prepared in the Basic Budget Worksheet. 9. Preliminary Budget incorporate data and payroll, fringes, depreciation, and facilities cost as computed by Corporate Planning. The preliminary data is returned to managers for review and any necessary changes. 10. Revisions made by managers to preliminary budget are sent to Corporate Planning on a timely basis. 11–13. Budgets are sent to senior vice president, and meetings are held to review budgets. Senior vice presidents will present their budgets and negotiate the necessary changes to bring budgets in line with corporate objectives. 14. Preparation of Budgeted P&L, Cash Flow, Balance Sheet by Corporate Planning and Finance Division. This will provide management with the financial picture of the budget year. 15–16. Budget Package sent to senior management for review and approval prior to presentation to ABC Company. 17. Presentation of Budget Package by Corporate Planning and president to ABC Company for approval. 18. Approved Budgets issued to respective departments. These will form the guide as to the upper limit of expenditures for the coming year.

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4 Break-even and Contribution Margin Analysis Profit, Cost, and Volume Changes

B

reak-even and contribution margin analysis, also known as cost-volume-profit (CVP) analysis, helps managers perform many useful analyses. It deals with how profit and costs change with a change in volume. More specifically, it looks at the effects on profits of changes in such factors as variable costs, fixed costs, selling prices, volume, and mix of products sold. By studying the relationships of costs, sales, and net income, management is better able to cope with many planning decisions. Break-even analysis determines the break-even sales. Break-even point—the financial crossover point when revenues exactly match costs—does not show up in corporate earnings reports, but managers find it an extremely useful measurement in a variety of ways.

Questions Answered by Break-even and Contribution Margin Analysis Break-even and contribution margin analysis tries to answer these five questions: 1. 2. 3. 4.

What sales volume is required to break even? What sales volume is necessary to earn a desired profit? What profit can be expected on a given sales volume? How would changes in selling price, variable costs, fixed costs, and output affect profits? 5. How would a change in the mix of products sold affect the break-even and target income volume and profit potential?

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Contribution Margin Income Statement The traditional income statement for external reporting shows the functional classification of costs, that is, manufacturing costs versus nonmanufacturing expenses (or operating expenses). An alternative format of income statement, known as the contribution margin income statement, organizes the costs by behavior rather than by function. It shows the relationship of variable costs and fixed costs a given cost item is associated with, regardless of the functions. The contribution approach to income determination provides data that are useful for managerial planning and decision making. The statement highlights the concept of contribution margin, which is the difference between sales and variable costs. The traditional format emphasizes the concept of gross margin, which is the difference between sales and cost of goods sold. These two concepts are independent and have nothing to do with each other. Gross margin is available to cover nonmanufacturing expenses, whereas contribution margin is available to cover fixed costs. A comparison is made between the traditional format and the contribution format below. Traditional Format Sales Less: Cost of Goods Sold Gross Margin Less: Operating Expenses Selling Administrative Net Income

Contribution Format $15,000 7,000 $8,000

$2,100 1,500

3,600 $4,400

Sales Less: Variable Expenses Manufacturing Selling Administrative Contribution Margin Less: Fixed Expenses Manufacturing Selling Administrative Net Income

$15,000 $4,000 1,600 500

$3,000 500 1,000

6,100 $8,900

4,500 $4,400

Contribution Margin For accurate break-even and contribution margin analysis, a distinction must be made between costs as being either variable or fixed. Mixed costs must be separated into their variable and fixed components (to be covered in Chapter 7). In order to compute the break-even point and perform various break-even and contribution margin analyses, note these important concepts. Contribution Margin (CM). The contribution margin is the excess of sales (S)

over the variable costs (VC) of the product or service. It is the amount of money available to cover fixed costs (FC) and to generate profit. Symbolically, CM S VC.

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Break-even and Contribution Margin Analysis

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Unit CM. The unit CM is the excess of the unit selling price (p) over the unit

variable cost (v). Symbolically, unit CM = p v. CM Ratio. The CM ratio is the contribution margin as a percentage of sales, that is, CM VC S VC 1 CM ratio S S S

The CM ratio can also be computed using per-unit data: pv Unit CM v CM ratio p 1 p p

Note that the CM ratio is 1 minus the variable cost ratio. For example, if variable costs account for 70 percent of the price, the CM ratio is 30 percent. Example 1 To illustrate the various concepts of CM, consider these data for Flip Toy Store:

Sales (1,500 units) Less: Variable costs Contribution margin Less: Fixed costs Net income

Total

Per Unit

Percentage

$37,500 15,000 $22,500 15,000 $ 7,500

$25 10 $15

100% 40 60%

From the data listed, CM, unit CM, and the CM ratio are computed as: CM S VC $37,500 $15,000 $22,500 Unit CM = p v = $25 $10 = $15 $22,500 CM $15 Unit CM 0.6 60% CM ratio 60% or p S $25 $37,500

Break-even Analysis The break-even point represents the level of sales revenue that equals the total of the variable and fixed costs for a given volume of output at a particular capacity use rate. For example, one might want to ask the break-even occupancy rate (or vacancy rate) for a hotel or the break-even load rate for an airliner. Generally, the lower the break-even point, the higher the profit and the less the operating risk, other things being equal. The break-even point also provides nonfinancial managers with insights into profit planning. It can be computed using these formulas: Fixed costs Break-even point in units Unit CM Fixed costs Break-even point in dollars CM ratio

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Example 2 Using the same data given in Example 1, where unit CM $25 $10 $15 and CM ratio 60%, we get: Break-even point in units $15,000/$15 1,000 units Break-even point in dollars $15,000/0.6 $25,000

Or, alternatively, 1,000 units $25 $25,000

Graphical Approach in a Spreadsheet Format The graphical approach to obtaining the break-even point is based on the so-called break-even (B–E) chart as shown in Exhibit 4.1. Sales revenue, variable costs, and fixed costs are plotted on the vertical axis while volume, x, is plotted on the horizontal axis. The break-even point is the point where the total sales revenue line intersects the total cost line. The chart can also effectively report profit potentials over a wide range of activity and therefore be used as a tool for discussion and presentation. The profit-volume (P–V) chart, as shown in Exhibit 4.2, focuses directly on how profits vary with changes in volume. Profits are plotted on the vertical axis while units of output are shown on the horizontal axis. The P–V chart provides

Exhibit 4.1 Break-even Chart 60,000 Profit

Sales and Costs ($)

50,000 40,000 Break-even Point

30,000

Variable Costs

20,000 Loss

2,500

2,000

1,500

1,000

500

Fixed Costs

0

10,000

Units of Output

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Exhibit 4.2 Profit-Volume (P-V) Chart 20,000 Profit

Profit ($)

10,000 0 Loss –10,000

2,500

2,000

1,500

1,000

500

0

–20,000

Units of Output

a quick condensed comparison of how alternatives on pricing, variable costs, or fixed costs may affect net income as volume changes. The P–V chart can be easily constructed from the B–E chart. Note that the slope of the chart is the unit CM. Determination of Target Income Volume Besides determining the break-even point, break-even and contribution margin analysis determines the sales required to attain a particular income level or target net income. The formula is: Fixed costs Target income Target income volume Unit CM

Example 3 Using the same data given in Example 1, assume that Flip Toy Store wishes to attain a target income of $15,000 before tax. Then the target income volume would be: $15,000 $15,000 $30,000 2,000 units $25$10 $15

Impact of Income Taxes If target income is given on an after-tax basis, the target income volume formula becomes: Fixed costs [Target after tax income/(1tax rate)] Target income volume Unit CM

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50 /


Example 4 Assume in Example 1 that Flip Toy Store wants to achieve an after-tax income of $6,000. The tax rate is 40 percent. Then $15,000 [$6,0001 (12 0.4)] Target income volume $15

$15,000 $10,000 1,667 units $15

Margin of Safety The margin of safety is a measure of difference between the actual sales and the break-even sales. It is the amount by which sales revenue may drop before losses begin, and is expressed as a percentage of expected sales: Break-even sales Margin of safety Expected sales

The margin of safety is used as a measure of operating risk. The larger the ratio, the safer the situation since there is less risk of reaching the break-even point. Example 5 Assume Flip Toy Store projects sales of $35,000 with a break-even sales level of $25,000. The projected margin of safety is $35,000 $25,000 $35,000

28.57%

Some Applications of Contribution Margin Analysis and “What-If” Analysis The concepts of contribution margin and the contribution income statement have many applications in profit planning and short-term decision making. Many “what-if” scenarios can be evaluated using them as planning tools, especially utilizing a spreadsheet program. Some applications are illustrated in Examples 6 to 10 using the same data as in Example 1. Example 6 Recall from Example 1 that Flip Toy Store has a CM of 60 percent and fixed costs of $15,000 per period. Assume that the company expects sales to go up by $10,000 for the next period. How much will income increase? Using the CM concepts, we can quickly compute the impact of a change in sales on profits. The formula for computing the impact is: Change in net income Dollar change in sales CM ratio

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Thus: Increase in net income $10,000 60% $6,000

Therefore, the income will go up by $6,000, assuming there is no change in fixed costs. If we are given a change in unit sales instead of dollars, then the formula becomes: Change in net income Change in unit sales Unit CM

Example 7 Assume that the store expects sales to go up by 400 units. How much will income increase? From Example 1, the company’s unit CM is $15. Again, assuming there is no change in fixed costs, the income will increase by $6,000. 400 units $15 $6,000

Example 8 What net income is expected on sales of $47,500? The answer is the difference between the CM and the fixed costs: CM: $47,500 60% Less: Fixed costs Net income

$28,500 15,000 $13,500

Example 9 Flip Toy Store is considering increasing the advertising budget by $5,000, which would increase sales revenue by $8,000. Should the advertising budget be increased? The answer is no, since the increase in the CM is less than the increased cost: Increase in CM: $8,000 60% Increase in advertising Decrease in net income

$4,800 5,000 $ (200)

Example 10 Consider the original data. Assume again that Flip Toy Store is currently selling 1,500 units per period. In an effort to increase sales, management is considering cutting its unit price by $5 and increasing the advertising budget by $1,000. If these two steps are taken, management feels that unit sales will go up by 60 percent. Should the two steps be taken?

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The answer can be obtained by developing comparative income statements in a contribution format:

Sales Less: Variable cost CM Less: Fixed costs Net income

(A) Present (1,500 Units)

(B) Proposed (2,400 Units)

(B – A) Difference

$37,500 (@$25) 15,000 $22,500 15,000 $ 7,500

$48,000 (@$20) 24,000 $24,000 16,000 $ 8,000

$10,500 9,000 $ 1,500 1,000 $ 500

The answer, therefore, is yes.

Sales Mix Analysis Break-even and cost-volume-profit analysis requires some additional computations and assumptions when a company produces and sells more than one product. In multiproduct firms, sales mix is an important factor in calculating an overall company break-even point. Different selling prices and different variable costs result in different unit CM and CM ratios. As a result, the break-even points and CVP relationships vary with the relative proportions of the products sold, called the sales mix. In break-even and CVP analysis, it is necessary to predetermine the sales mix and then compute a weighted average unit CM. It is also necessary to assume that the sales mix does not change for a specified period. The break-even formula for the company as a whole is: Fixed Costs Break-even sales in units (or in dollars) Weighted Average Unit CM (or CM Ratio)

Example 11 Assume that Knibex, Inc., produces cutlery sets out of high-quality wood and steel. The company makes a deluxe cutlery set and a standard set that have these unit CM data:

Selling price Variable cost per unit Unit CM Sales mix Fixed costs

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Deluxe

Standard

$15 12 $ 3

$10 5 $ 5

60% 40% (based on sales volume) $76,000

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The weighted average unit CM = ($3)(0.6) + ($5)(0.4) = $3.80. Therefore, the company’s break-even point in units is: $76,000 $3.80

= 20,000 units

Which is divided in this way: Deluxe: 20,000 units 60% = 12,000 units Standard: 20,000 units 40% = 8,000 20,000 units

Note: An alternative is to build a package containing 3 deluxe models and 2 standard models (3:2 ratio). By defining the product as a package, the multiple-product problem is converted into a single-product one. Then follow the next three steps. Step 1. Compute the package CM. Deluxe Selling price Variable cost per unit Unit CM Sales mix Package CM

Standard

$15 $10 12 5 $ 3 $ 5 3 2 $ 9 $10 $19 package total

$76,000/$19 per package = 4,000 packages

Step 2. Multiply this number by their respective mix units. Deluxe: 4,000 packages 3 units = 12,000 units Standard: 4,000 packages 2 units = 8,000 20,000 units

Example 12 Assume that Dante, Inc., is a producer of recreational equipment. It expects to produce and sell three types of sleeping bags—the Economy, the Regular, and the Backpacker. Information on the bags follows. Budgeted Economy

Regular

Backpacker

Total

Sales Sales mix Less VC

$30,000 30% 24,000

$10,000 10% 5,000

$100,000 100% 69,000

CM

(80%)* $ 6,000

$ 60,000 60% 40,000 (66²⁄³%)

(50%) $ 5,000

(69%) $ 31,000†

50%

31% $ 18,600 $ 12,400

CM ratio Fixed costs Net income

20%

$ 20,000 ı 33 ⁄³%

*

$24,000/$30,000 = 80% $31,000/$100,000 = 31%

†

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The CM ratio for Dante, Inc., is $31,000/$100,000 = 31 percent. Therefore, the break-even point in dollars is $18,600 0.31

= $60,000

which will be split in the mix ratio of 3:6:1 to give us these break-even points for the individual products: Economy: $60,000 30% $18,000 Regular: $60,000 60% 36,000 Backpacker: $60,000 10% 6,000 $60,000

One of the most important assumptions underlying CVP analysis in a multiproduct firm is that the sales mix will not change during the planning period. But if the sales mix changes, the break-even point will also change. Example 13 Assume that total sales from Example 12 was achieved at $100,000 but that an actual mix came out differently from the budgeted mix (i.e., for Economy, 30% to 55%; for Regular, 60% to 40%; and for Backpacker, 10% to 5%). Actual

Sales Sales mix Less: VC CM CM ratio Fixed Costs Net income

Economy

Regular

Backpacker

Total

$55,000 55% 44,000* (80%) $11,000

$40,000 40% 26,667* (66²⁄³%) $13,333 ı 33 ⁄³%

$5,000 5% 2,500* (50%) $2,500

$100,000 100% 69,000 (69%) $ 26,833

50%

26.83%† $ 18,600 $ 8,233

20%

$55,000 × 80% $44,000; $40,000 66.23% $26,667; $5,000 × 50% $2,500 $26,833/$100,000 26.83%

* †

Note: The shift in sales mix toward the less profitable line, Economy, has caused the CM ratio for the company as a whole to drop from 31 percent to 26.83 percent. The new break-even point will be $18,600/0.2683 = $69,325. The break-even dollar volume has increased from $60,000 to $69,325. The deterioration (improvement) in the mix caused net income to go down (up). It is important to note that, generally, the shift of emphasis from lowmargin products to high-margin ones will increase the overall profits of the company.

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Example 14 (Sales Mix Analysis for Service Organizations) The City Ballet Company features five different ballets per year. For the upcoming season, the five ballets to be performed are The Dream, Petroushka, The Nutcracker, Sleeping Beauty, and Bugaku. The general manager has tentatively scheduled the following number of performances for each ballet for the coming season: 5 5 20 10 5

Dream: Petroushka: Nutcracker: Sleeping Beauty: Bugaku:

To produce each ballet, costs must be incurred for costumes, props, rehearsals, royalties, guest artist fees, choreography, salaries of production staff, music, and wardrobe. These costs are fixed for a particular ballet regardless of the number of performances. The direct fixed costs for each ballet are: Dream: Petroushka: Nutcracker: Sleeping Beauty: Bugaku:

$275,500 $145,500 $ 70,500 $345,000 $155,500

Other fixed costs are incurred: Advertising: Insurance: Administrative salaries: Office rental, phone, and so on: Total:

$ 80,000 15,000 222,000 84,000 $401,000

For each performance of each ballet, these costs also are incurred: City Symphony: $3,800 Auditorium rental: 700 Dancers’ payroll: 4,000 Total: $8,500

The auditorium in which the ballet is presented has 1,854 seats, which are classified as A, B, and C. The best viewing ranges from A seats to C seats. Information concerning the different types of seats follows.

Quantity Price

A Seats

B Seats

C Seats

114 $35

756 $25

984 $15

Percentage sold for each performance.* Nutcracker All others

100 100

100 80

100 75

*Based on past experience, the same percentages are expected for the coming season.

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The expected revenues from the performances that have been tentatively scheduled can be calculated in this way: Number of seats sold (expected): Seats sold Number of performances Capacity Percent sold Type of Seat

Dream Petroushka Nutcracker Sleeping Beauty Bugaku

A

B

C

570 570 2,280 1,140 570 5,130

3,024 3,024 15,120 6,048 3,024 30,240

3,690 3,690 19,680 7,380 3,690 38,130

Total revenues ($35 5,130) ($25 30,240) ($15 38,130) $179,550 $756,000 $571,950 $1,507,500

Segmented revenues (Seat price ⴛ Total seats): Dream Petroushka Nutcracker Sleeping Beauty Bugaku

A

B

C

Total

$19,950 19,950 79,800 39,900 19,950

$ 75,600 75,600 378,000 151,200 75,600

$ 55,350 55,350 295,200 110,700 55,350

$150,900 150,900 753,000 301,800 150,900

Segmented income statement: Dream Sales Variable expenses Contribution margin Direct fixed expenses Segment margin

Sales Variable expenses Contribution margin Direct fixed expenses Segment margin Common fixed expenses Operating income

$150,900 42,500 $108,400 275,500 $(167,100)

Petroushka $150,900 42,500 $108,400 145,500 $(37,100)

Sleeping Beauty

Bugaku

$301,800 85,000 $216,800 345,000 $(128,200)

$150,900 42,500 $108,400 155,500 $(47,100)

Nutcracker $753,000 170,000 $583,000 70,500 $512,500 Total $1,507,500 382,500 $1,125,000 992,000 $ 133,000 401,000 $(268,000)

The computation of the number of performances of each ballet required for the company as a whole to break-even requires two steps:

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Step 1. Computer-weighted contribution margin (package). Note that the current mix is 1:1:4:2:1. $21,680 $21,680 4($29,150) 2($21,680) $21,680 $225,000 Packages ($992,000 + $401,000)/$225,000 6.19 or 7 packages (rounded up)

Step 2. Multiply this number by their respective mix units. This yields the following number of performances: 7 Dream 7 Petroushka 28 Nutcracker 17 Sleeping Beauty 7 Bugaku

(1 7) (1 7) (4 7) (2 7) (1 7)

Contribution Margin Analysis and Nonprofit Organizations Break-even and contribution margin analysis is not limited to profit firms. It not only calculates the break-even service level for nonprofit organizations, but helps answer a variety of “what-if ” decision questions. Example 15 OCM, Inc., a Los Angeles county agency, has a $1,200,000 lump-sum annual budget appropriation for an agency to help rehabilitate mentally ill patients. On top of this, the agency charges each patient $600 a month for board and care. All of the appropriation and revenue must be spent. The variable costs for rehabilitation activity average $700 per patient per month. The agency’s annual fixed costs are $800,000. The agency manager wishes to know how many patients can be served. Let x = number of patients to be served. Revenue Total expenses Lump-sum appropriation + $600 (12) x Variable expenses Fixed costs $1,200,000 $7,200 x $8,400 x $800,000 ($7,200 $8,400) x $800,000 $1,200,000 $1,200 x $400,000 x $400,000/$1,200 x 333 patients

We will investigate two “what-if” scenarios: (1) Suppose the manager of the agency is concerned that the total budget for the coming year will be cut by 10% to a new amount of $1,080,000. All other things remain unchanged. The manager wants to know how this budget cut affects the next year’s service level. $1,080,000 $7,200 x $8,400 x $800,000 ($7,200 $8,400) x $800,000 $1,080,000 $1,200 x $280,000 x $280,000/$1,200 x 233 patients

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(2) The manager does not reduce the number of patients served despite a budget cut of 10%. All other things remain unchanged. How much more does the manager have to charge patients for board and care? In this case, x = board and care charge per year. $1,080,000 333 x $8,400 (333) x $800,000 333 x $2,797,200 $800,000 $1,080,000 333 x $2,517,200 x $2,517,200/333 patients x $7,559

Thus, the monthly board and care charge must be increased to $630 ($7,559/12 months).

CVP Analysis with Step-function Costs The introduction of step-function costs is somewhat more difficult than it might first appear. Ideally, we would like to be able to assume that, for any given relevant range, we could simply add together the step-function costs and the fixed costs to give us the total applicable fixed costs. We then could utilize the formula as described earlier. Unfortunately, the process is not quite that simple, as the next example illustrates. Example 16 Amco Magazine Company publishes a monthly magazine. The company has fixed costs of $100,000 a month, variable costs per magazine of $.80, and charges $1.80 per magazine. In addition, the company also has supervisory costs. These costs behave in this way: Volume

Costs

0–50,000 50,001–100,000 100,001–150,000

$10,000 20,000 30,000

Amco’s monthly break-even volume (number of magazines) can be calculated step by step. If we attempt to solve the break-even formula at the first level of fixed costs, we have this equation: x FC/(p v) ($100,000 10,000)/($1.80 $.80) $110,000/.$1 110.000 units

The problem with this solution is that, while the break-even volume is 110,000 magazines, the relevant range for the step-function costs was only 0–50,000

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magazines. Thus, a break-even of greater than 50,000 magazines is invalid, and we must move to the next step on the step function, which gives us the next equation: x FC/(p v) ($100,000 20,000)/($1.80 $.80) $120,000/.$1 120,000 units

This solution is also invalid. Only when we get to the third level do we encounter a valid solution: x FC/(p v) ($100,000 30,000)/($1.80 $.80) $130,000/.$1 130,000 units

The conclusion we must draw is that the incorporation of step-function costs in the CVP formula requires a trial-and-error process to reach the break-even volume. From a profit-seeking perspective, a 150,000 unit level is most profitable. 50,000 CM(@1) $ 50,000 FC 100,000 NI ($ 50,000)

100,000

150,000

$100,000 120,000 ($ 20,000)

$150,000 130,000 $ 20,000

Assumptions Underlying Break-even Contribution Margin Analysis The basic break-even and contribution margin models are subject to six limiting assumptions. They are: 1. The selling price per unit is constant throughout the entire relevant range of activity. 2. All costs are classified as fixed or variable. 3. The variable cost per unit is constant. 4. There is only one product or a constant sales mix. 5. Inventories do not change significantly from period to period. 6. Volume is the only factor affecting variable costs.

Conclusion Break-even and contribution margin analysis is useful as a frame of reference, as a vehicle for expressing overall managerial performance, and as a planning device via break-even techniques and “what-if” scenarios.

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The next points highlight the analytical usefulness of contribution margin analysis as a tool for profit planning: ■

■

■

■

■

■

A change in either the selling price or the variable cost per unit alters CM or the CM ratio and thus the break-even point. As sales exceed the break-even point, a higher unit CM or CM ratio will result in greater profits than a small unit CM or CM ratio. The lower the break-even sales, the less risky the business and the safer the investment, other things being equal. A large margin of safety means lower operating risk since a large decrease in sales can occur before losses are experienced. Using the contribution income statement model and a spreadsheet program, such as Excel, a variety of “what-if” planning and decision scenarios can be evaluated. In a multiproduct firm, sales mix is often more important than overall market share. The emphasis on high-margin products tends to maximize overall profits of the firm.

We discussed how the traditional contribution analysis can be applied to the profit and nonprofit setting. Illustrations were provided. Managers can prepare the income statement in a contribution format, which organizes costs by behavior rather than by the functions of manufacturing, sales, and administration. The contribution income statement is widely used as an internal planning and decisionmaking tool.

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5 Profit Planning Targeting and Reaching Achievable Goals

I

n profit planning, we must determine the strategy, which is one of several ways to reach a goal. But we must also determine the objective, which is the target that can be quantified and that is developed from analysis of the situation at present and in the future. And finally, we must see what is needed to implement the plan. Profit planning involves setting realistic profit objectives and targets and accomplishing them. The plan must consider the organization structure, product line (e.g., up-to-date, obsolete), services rendered, selling prices, sales volume, costs (manufacturing and operating expenses), market share, territories, skill of labor force, sources of supply, economic conditions, political environment, risk, salesforce effectiveness, financial health (e.g., cash flow to fund programs), physical resources and condition, production schedules, human resources (e.g., number and quality of employees, training programs, relationship with union), distribution facilities, growth rate, technological ability, motivational aspects, and publicity. Each part of the plan must be evaluated for reasonableness as well as for its effect on other parts of the plan. Trouble spots must be identified and corrected. Information should be in the simplest and clearest form. Profits may be increased by increasing revenue (selling price and/or sales volume) and reducing costs, eliminating duplication of work and inconsistencies. Managers can improve profitability of their responsibility unit by: ■

■

■

Operating the department with the minimum number of employees. This may include downsizing through layoffs. Reducing operating costs, such as using automation and robotics to replace the cost of manual labor Buying rather than leasing when cost beneficial 61

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■ ■ ■ ■ ■

■ ■ ■

■ ■

/


Emphasizing previous success. For example, if growth has come from product development, then allocate more funds to research and development (R&D) Keeping up-to-date Using high-technology equipment Self-constructing assets when feasible Eliminating useless operations and paperwork (e.g., reports) Being productive and progressive in obtaining efficiencies realizable with existing resources and capabilities Improving the reliability of the product and service Expanding into new operations and areas so every opportunity is pursued Improving supplier relationships, including negotiating better prices and terms. Alternative sources of supply may be bought when cost effective. Screening new hires for honesty and competence Having adequate insurance, including business interruption and product liability

The profit plan should be in writing, consistently applied, and contain these key elements: ■ ■

■ ■ ■ ■ ■

Statement of objectives Parameters of achieving those objectives (e.g., prohibition of reducing discretionary costs, such as R&D, in the current year just to bolster near-term profits when this will have long-term negative effects) Plans (operating and financial) Schedules Ways to measure and track performance Review procedures Mechanism for making needed changes

An operating plan tells how the objective is to be achieved. For example, an operating plan for a sales manager may provide for a reduction in selling expenses of 10 percent by improving salesperson productivity through better training, reducing the number of salespeople, and increasing the number of calls per salesperson. The financial plan is a budget expressed in dollars that quantifies the operating plan. Lower-level managers are more involved with operational specifics (details) and carrying out plans than upper-level managers. Planning should occur within a reasonable time frame, not rushed, considering alternatives that accomplish the long-term objectives of the manager. For example, a new product should undergo test marketing before it is introduced on a massive scale. Further, profit planning for the next year should begin as early as possible. It must be in place by January 1 of that year.

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The profit plan may be for one year and multiyears. For example, in a five-year plan, there should be profit objectives set for each of the years included in that plan. A five-year plan should be the maximum time period because the longer the time horizon, the more difficult it is to predict. Further, a five-year period would be more practical and attainable than longer periods. The time period chosen should take into account the nature and stability of the business. Reports should provide managers with the right information needed to make a good decision. Once that decision has been made, control reports should show whether it has worked out or not. Further, managers should not procrastinate once they have made a decision. Managers should not keep changing their mind because of employee reaction. Managers must address what is crucial. For example, material costs are important to a manufacturing company but not to a financial service business. In airlines, passenger revenue per mile is crucial. Information has to be given to the right managers and must directly relate to their operations. The type of profit plan and its components will differ among companies, depending on their unique characteristics, features, problems, conditions, and requirements. Unfortunately, profit planning has become more difficult because of competition, the high cost associated with introducing new products (e.g., R&D), more educated consumers, and government regulation. This chapter discusses establishing and evaluating profit targets, planning objectives, role of nonfinancial managers, plan assumptions and alternatives, manager responsibilities, participation in the planning process, employee relations, coordination and communication, scheduling, handling problems, and analysis and control of the profit plan.

Goal Congruence We must keep in mind goal congruence, which is top management’s viewpoint agreeing with the lower-level managers’ viewpoint. Some of this activity could be misdirected if each manager assumes, as is human, that what is best for his or her responsibility center is best for the company. Therefore, the manager must consider general company goals and assumptions as a background for all planning activity. The standard philosophy is that more is better; that is, more sales, products, fields of activity, profit, and return. Most businesses feel that ceasing to grow is beginning to die.

Profit Targets Profit planning sets a target profit that takes into account expected sales and costs for next year and for longer periods. The manager should track, on a regular basis, the progress in meeting the profit plan so any needed adjustments may be made in selling effort or cost containment. For example, if the yearly target is an increase

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in sales of 20 percent and in the first quarter sales have actually decreased by 2 percent, a problem is indicated. Yet if the plan calls for a reduction in yearly costs of 10 percent and at the end of the second quarter costs have been trimmed by 12 percent, the situation is quite favorable. A profit target can apply to the individual components of that profit. For example, a company that now derives 80 percent of its earnings from one product may have as its profit goal in three years to derive 40 percent of its profit from this product and 60 percent of its profit from other products. This goal may be achieved through developing new products, enhancing existing products, change in advertising and sales promotion, and R&D efforts.

Objectives in the Profit Plan An objective states what is going to be done. The objective must be clear, quantifiable, compatible, practical, strong, realistic, and attainable. The objective should be in writing. Objectives changed too often become meaningless. Further, objectives must not conflict with each other. The objective must be specific. For example, an objective of increasing sales should state by how much, where, and when. It may take this form: “The divisional objective is to increase sales by 50,000 units of product X in territory A for 20XX.” The manager should clearly communicate objectives to subordinates. Objectives should be established in priority order. An example is a marketing department that should give primary emphasis to the existing, successful product line and secondary emphasis to unproven, high-risk new products. Another example is the R&D manager who should give first priority to basic research to improve the existing products and a lower level of priority to research on new products. Objectives should be ranked in terms of those having the highest return. The progress toward meeting the objective should be measured at regular intervals (e.g., quarterly).

Role of Nonfinancial Managers The nonfinancial manager must abandon sacred cows to increase profits. For example, a less expensive raw material may be used to result in cost savings without sacrificing product quality. Another example is to lower the quality of a product to save on costs and reduce the selling price to attract more business from price-oriented customers. A company that sells only to a few prestigious accounts that are willing to pay a higher price may produce greater overall profits by lowering the quality and price to get a huge number of price-sensitive accounts. Conversely, the company may keep its high-priced product as is and develop a new second product line of lower prices with a different label to attract the price-conscious consumer. The marketing manager may increase profits by increasing the selling price, increasing volume, improving quality and service, reducing the time to respond

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to customer complaints, concentrating on high-demand products, modifying geographic locations, having clean facilities, altering distribution outlets, introducing new products, redesigning packaging, using more attractive styling, discontinuing unprofitable products, increasing personal selling, changing the sales force, and modifying advertising and sales promotion policy. The marketing manager should determine how much of each sales dollar goes to meeting marketing expenses. He or she should determine the ratio of the change in marketing expenses over the year to expenses last year to indicate the degree of cost control. The manager must also keep abreast of marketing trends for products and services. The manager should rate salespeople in terms of the net profitability brought in. A comparison should be made between the salesperson’s actual sales relative to the costs to obtain those sales. Other performance measures are dollar sales quotas and the number of orders from existing and new customers. A sales analysis should examine orders booked, orders backlogged, orders lost by out-of-stock or delayed shipments, ratio of orders billed to orders booked, and aging of orders. A sales effort analysis involves the number of sales calls, number of advertisements and mailings, number of new customers, market share, and sales mix. The production manager can maximize profits by spreading manufacturing as regularly as possible over the entire year. This may add stability to manufacturing and lower costs (e.g., eliminate overtime, layoffs versus rehiring and training). The manager may also increase profits through private labeling for other companies. This would achieve better plant and machinery utilization and spread fixed costs over more units. The manager should also maintain plant facilities, obtain givebacks from employees or not give raises, derive optimum inventory balances and reduce inventory costs, lower raw material costs, and properly schedule production. The production manager should use these factory performance measures: capacity in use and units produced, percentage of rejects and rework, yield percentages for direct materials and purchased parts, and trends in costs of service, especially during new product learning curve periods. The purchasing manager can increase profits by properly timing the purchase of raw materials, obtaining volume and cash discounts, changing suppliers to obtain lower prices (assuming reliability in delivery), and inspecting items to ensure quality. The transportation manager can boost profits by scheduling delivery routes to economize on time and by lowering mileage costs, including fuel and depreciation. The personnel manager can improve profits by instituting an incentive plan to improve dollar revenue per employee and sales volume per worker. The ratio of annual terminations to the average number of employees can also be examined. The research director can contribute by substituting low-cost components for high-cost ones without sacrificing quality or customer acceptance. The engineering manager can reduce the number of diverse elements in use (e.g., 100) to standardized ones (e.g., 20), and find fewer cost combinations of inputs (e.g., materials and labor mix).

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The service manager is concerned with the percentage of billable time, standard and average billing rate, average cost per hour of employee time, and overhead (or markup) rate to labor time. The manager should maintain a system that can differentiate quickly and accurately between customers based on the degree of service they require and the revenues their patronage is likely to generate. The credit manager can reduce bad debts and the collection period without losing sales. Because a nonfinancial manager ’s responsibility is to plan and control, he or she must be able to communicate effectively in order to accomplish goals. Communication may be written (formal financial reports, ratio, statistics, narrative), graphical (charts, diagrams, pictures), and oral (conferences, group meetings).

Assumptions Profit plans rely on assumptions and projections. Nonfinancial managers will have to make assumptions in order to predict the future. The assumptions must be continually updated. Any revisions require special approval. If the assumptions are not realistic—for example, for an increase in selling price if there is a high degree of competition and/or a recession—the basis of the profit plan is in doubt. Further, an increase in selling price may result in a decline in sales volume, hurting overall profits because consumers will switch to cheaper brands (e.g., away from Philip Morris cigarettes).

Alternatives The financial impact of alternatives in the profit plan has to be considered. Alternative plans can allow for such possibilities as a strike. The alternative selected should be practical and result in the highest profit in conformity with the nonfinancial manager ’s goals. The bottom line, and not the personal tastes of the manager, is all that counts. For example, the sales manager may prefer to sell through direct mail, but he or she should use the manufacturer ’s representatives if that is more profitable. The sales manager should try to obtain the most profitable sales at the minimum cost. Some of the sales manager ’s options are: ■ ■ ■ ■ ■ ■ ■ ■

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Modify advertising and sales promotion. Change the method of distribution. Eliminate unprofitable products. Develop new markets and products. Combine small orders to reduce transportation charges. Redesign truck routes to economize on fuel. Change the sales territory. Alter the selling price.

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Change credit and collection policies. Alter packaging and labeling.

The production manager is responsible for manufacturing sufficient quantities to meet sales needs at the lowest practical cost while maintaining quality within a desired time period. ■ ■ ■ ■ ■ ■ ■ ■

Improve the production process and supervision of workers. Change the repair and maintenance policy. Move production elements (e.g., machinery) or entire facilities. Use higher-technology equipment. Determine the best production run. Properly schedule work flow and employee time. Synchronize production and inventory levels. Reduce fixed costs.

The purchasing manager is responsible for buying materials and supplies at the least cost while maintaining quality. The purchasing manager should: ■ ■ ■ ■ ■ ■ ■

Carefully inspect the quality of purchased items. Decrease the days that elapse between purchase and delivery. Decide on less expensive product substitutes. Obtain volume discounts from larger orders. Reduce inventory cost with more frequent deliveries. Emphasize standardized (uniform) items. Change unreliable suppliers. The personnel manager can:

■ ■ ■ ■

Expand job training. Improve recruitment. Establish merit increases based on performance. Select the right person for the right job.

Responsibility Profit planning requires that managers be held accountable for their results if they have authority over the items in question. Responsibility without authority causes the profit planning system to fail and results in manager frustration. Planning should avoid conflicts that have a net negative profit impact on the business. An example is a sales manager who accepts short-term, low-volume

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sales orders even though they result in unusually high manufacturing costs for the production manager. A solution is to make nonfinancial managers jointly responsible for an objective that affects both. Interrelated departments must work as a group to maximize company profit by considering the net advantage or disadvantage to the business. The managers should share credit or blame for these interrelated performances. In this way, managers will work toward meeting overall company objectives. Each manager must determine whether responsibility unit managers are contributing to the profit plan in the expected proportion.

Participation Profit planning involves effort and input by managers in sales, production, distribution, research and development, service, engineering, finance, traffic, and general business. Line managers are concerned with operating and executing plans. Staff managers assist others in an advisory capacity. In either case, the manager must be able to change and try new things. Financial people should spend time with operating personnel to familiarize themselves with operations, problems, and requirements. Managers should encourage financial personnel to discuss with them the nature and characteristics of their department’s or responsibility unit’s operations. In this way, the accountant or financial executive can prepare meaningful budget information and performance reports that can be used by nonfinancial managers. Managers should insist on getting reports, schedules, and forms that are useful. Otherwise, the information may not be suitable or relevant and will be discarded. Nonfinancial managers should communicate clearly to financial managers the type and nature of information they need. Otherwise, time and money will be wasted on useless information for managers. As a result, the managers may waste time accumulating accounting numbers themselves.

Subordinates Managers should monitor the performance of subordinates but should give them latitude in making decisions. Subordinates should be rewarded (e.g., salary increases, merit bonuses) on the basis of results that improve divisional profitability. The optimum pay raise is the minimum pay increase that will yield the maximum productivity increase. Managers whose decisions have hurt profitability should be called to account. They should learn from their errors. If too many errors have been made, a replacement might be appropriate. Compensation to subordinates should be competitive with other companies in the industry. No limit should be placed on salaries or the successful employee may quit.

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Coordination Profit planning is a team effort involving all managers, line and staff, to accomplish the profit goal. For example, there should be coordination among the sales manager, production supervisor, purchasing manager, receiving manager, director of engineering, and quality control supervisor, because interrelationships exist between them.

Scheduling A product introduced should be planned and scheduled in the most economical way. Workers should be available when needed. Each step should proceed logically. Profit planning involves delivering products on time by such means as reducing workers’ absentee rates.

Problems Problems must be identified, addressed with solutions, and profit impacts considered. If the problems cannot be rectified (e.g., they are uncontrollable by the company), the adverse effects must also be taken into account. An example is when a manufacturer loses some retail accounts because of competitors’ price cuts and an existing poor relationship between the manufacturer and the retailers because of delivery delays due to a strike.

Control, Evaluation, and Analysis A management information system (MIS) includes financial information that allows the manager to compare actual results with target figures. It is better to analyze variances “—preferably” monthly. For example, quarterly variance analysis may be too late to give managers the opportunity to correct problems. A comparison should be made over time between actual profit and budgeted profit. Related useful ratios are actual revenue to budgeted revenue and actual costs to budgeted costs. The profit expectation of the plan should be compared to prior years’ experience as an indicator of reasonableness. For example, it may not be reasonable to project a sales increase for next year of 40 percent when in previous years the sales increase has never exceeded 20 percent. There must be hard evidence (e.g., something in the current year and expected for a future year to justify it) for this dramatic increase. The projections in the profit plan should be compared to competing companies’ experiences. For example, company X will start a new program or project if it earns a rate of return of 30 percent. However, six competing companies have already tried this program or project and either have lost money or earned a return rate below 5 percent. This makes the company’s projected 30 percent rate of return questionable unless special or unique reasons to justify it can be shown.

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Ratios may be prepared comparing projected performance to historical performance. Some useful ratios include return on investment (ROI) (net income/total assets), profit margin (net income/sales), cost of sales to sales, direct material to sales, direct labor to sales, factory overhead to sales, selling expenses to sales, and general and administrative expenses to sales. However, in making ratio calculations, the data must be comparable over the years. The manager should not overstate current year profit at the expense of sacrificing future profitability. The manager must track the status of a project or program and make immediate decisions if an operation is not productive or profitable. Further, part of a department that no longer serves a useful purpose may be disbanded. A comparison may be made between the unit costs of the old and the new manufacturing operation to see if the latter is successful. After a product has been marketed, the company must continually evaluate and improve it, based on customer reaction. Feedback should occur on a timely basis so that necessary corrective steps may be taken. In order to make valid comparisons between the company and a competitor, there must be a comparable base. For example, if one company has old and inefficient plant facilities, it is not comparable to one with modern, efficient facilities. An illustrative profit plan is presented in Exhibit 5.1.

Internal Controls Internal controls are fundamental in profit planning. Assets should be safeguarded and controlled. An individual’s work should be checked by another. One person should not have control over a transaction from beginning to end. Requests and requisitions should be reviewed and approved. Before an item is paid, make certain it is appropriate.

Real-life Illustrations in Profit Planning Staples, the office supply company, achieves the lowest net-landed cost in the entire office stationery business. But it also targets small business companies employing fewer than 50 people. To further the relationship with this market segment, Staples has created a club. Customers join at no extra cost and get at least a 5 percent discount on fast-moving items. In order to get the discount, the customers must show their cards, allowing Staples to track sales by customer and gain useful data for satisfying its market. Some store managers now have incentives based on customer satisfaction. Some companies look at a customer ’s lifetime value to the company, not the value of a single transaction. Home Depot is an example of such a company. Clerks do not spend time with customers to be nice. They do so because the company’s business strategy is built around not only selling home repair and

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Operating Profit

Total Expenses

Selling Expenses

General & Administrative Expenses

Cost of Goods Sold

Expenses

Net Sales

Discounts

Less: Returns

Dollars

Units

Sales

Jan.

Feb.

Mar.

Profit Plan

Exhibit 5.1

First Quarter

Remainder of Year

Total for Year

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improvement items inexpensively, but around customers’ needs for information and service. Although new products win new markets, it may be better in some cases to stick with existing customer segments. It is easier to build sales volume with customers who already know the company. When Entenmann’s of New York, a loyalty leader in specialty bakery products, saw its sales leveling off, it monitored customer purchase patterns in each local market. Through telephone surveys and focus groups, the company found that customers were looking for fat-free and cholesterol-free items. Entenmann’s determined that it was much more economical to develop new health products than to go with another group of customers. Its new product line has been highly successful by addressing the changing needs of the core clientele and also attracting new customers. The Olive Garden restaurant chain is another company that believes that customer loyalty plays a major role in profit planning. The chain goes against the norm of promoting successful managers to other restaurants every few years and letting assistants take over. It hires local managers whose major asset is that they are known and trusted in the community. Managers stay where they are. They get to know the customers, and their longtime hires add value to the company. It is with employees that the customer builds a bond of trust and expectations. When those people leave, the bond is broken. Another company that uses this same philosophy is State Farm, the insurance company. Its focus on customer service has resulted in faster growth then most other multiple-line insurers. But rather than being consumed by growth, its capital has mushroomed (all through internally generated surplus) to more than $18 billion, representing the largest capital base of any financial services company in North America. State Farm began by choosing the right customers. Because of this, it was still able to build the capital necessary to protect its policyholders in years such as 2005, when the company incurred some $6 billion in catastrophe losses. State Farm agents work from neighborhood offices, which allows them to build long-lasting relationships with their customers and provide personal service. For example, agents scan the local newspaper for the high school honor roll and are sure that their young customers’ good grades are recognized with discounts. Commissions are structured to encourage long-term thinking. Rather than bringing in lots of new customers, the company’s marketing efforts encourage existing customers to buy additional products, such as home and life insurance. State Farm’s success in building customer loyalty is reflected in retention rates that exceed 90 percent, consistently the best performance of all the national insurers that sell through agents. Dell Computer has focused on operational excellence to boost profits. Operational excellence is a specific strategy involving the production and delivery of products and services. The objective of this strategy is to lead its industry in price and convenience. Dell’s goal is to show PC buyers that they do not have to sacrifice quality or state-of-the-art technology in order to buy personal computers easily and inexpensively.

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In the mid-1980s, while Compaq concentrated on making its PCs less expensive and faster than IBM’s, Dell saw the opportunity to outdo both IBM and Compaq by focusing not on the product, but on the delivery system. Dell came onto the scene with a radically different and far more efficient operating mode. Dell realized that Compaq’s marketing strategy of selling PCs through dealers to novices could be outperformed by a model that cut dealers out of the distribution process altogether. By selling to customers directly, building to order rather than to inventory, and creating a disciplined and extremely low-cost culture, Dell has been able to undercut Compaq and other PC manufacturers in price and service. While Dell has risen to $1.7 billion in revenue in less than 10 years, the Competitor has been forced to cut prices and overhead. In 2007, Dell had sales of $57 billion. Global competition, changing markets, and new technologies are opening new roads to reinvent value. IKEA is one company that accomplished this. It changed from a small Swedish mail-order furniture operation into the world’s largest retailer of home furnishings, with a global network of 260 enormous stores. In 2007, these stores were visited by more than 583 million people, generated revenues of 26 billion, and had an average annual growth rate of 15 percent with profit margins estimated between 8 and 10 percent. The IKEA’s catalogue is mass distributed to 191 million house-holds, free of charge. IKEA’s huge suburban stores sell simple high-quality knock-down furniture kits that customers transport and assemble themselves. IKEA passes down a portion of what it saves on low-cost components, efficient warehousing, and customer self-service to its customers in the form of lower prices—anywhere from 25 to 50 percent below those of competitors. IKEA’s strategy is to allow customers to take on key tasks that were traditionally done by manufacturers and retailers, such as the assembly of products and delivery to customers’ homes. And for doing this it promises substantially lower prices. Part of IKEA’s goal is to make itself not just a furniture store but a family outing destination. It provides free strollers, child care, and playgrounds as well as wheelchairs for the disabled and elderly. IKEA stores also have dining facilities. IKEA’s strategic intent is to have its customers understand that their role is not to consume value but to create it. It provides customers with catalogs, tape measures, pens, and notepaper to help them make choices without the need of salespeople. IKEA’s goal is not to relieve customers of doing certain tasks but to mobilize them to do easily certain things they have never done before. IKEA has set out to reinvent value and the business system that delivers value for customers and suppliers alike. The question is “Does IKEA offer a product or a service?” The answer is neither—and both. This change of values can be compared to cash withdrawals from automatic teller machines (ATMs). Not long ago, it was inconceivable that a customer would replace a personal relationship with a bank teller for a computer system. But today most cash withdrawals come from ATMs.

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There are many implications for profit planning. ■

■

■

■

Value for customers can be restated to mobilize customers to take advantage and create value for themselves. Companies do not compete with each other anymore. Rather, it is the offerings that compete for the customers’ money. A result of a company’s strategic task is the reconfiguration of its relationships and business systems. To win at this strategy, the key is to keep offerings competitive. This is why IKEA has become the world’s largest furniture retailer, using a strategy that could be applied to many industries.

Conclusion A profit plan may be stated as target return on investment (e.g., 20 percent ROI), growth in earnings (e.g., 5 percent) or in earnings per share and percentage of sales. Performance reporting compares actual results with expectations. All efforts must be expended to accomplish profit goals. Problems have to be identified and addressed immediately. The manager should rank items in terms of profit potential and growth.

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6 Master Budget Genesis of Financial Forecasting and Profit Planning

A

comprehensive—master—budget is a formal statement of management’s expectation regarding sales, expenses, volume, and other financial transactions for the coming period. It consists basically of a pro forma income statement, pro forma balance sheet, and cash budget. At the beginning of the period, the budget is a plan or standard. At the end, it serves as a control device to help management measure its performance against the plan so that future performance may be improved. With the aid of computer technology, budgeting can be used as an effective device for evaluation of “what-if ” scenarios. Management can find the best course of action among various alternatives through simulation. If management does not like what it sees on the budgeted financial statements in terms of financial ratios such as liquidity, activity (turnover), leverage, profit margin, and market value ratios, it can always alter its contemplated decision and planning set. The budget is classified broadly into two categories: 1. Operating budget 2. Financial budget The operating budget consists of:

■ ■ ■ ■ ■

Sales budget Production budget Direct materials budget Direct labor budget Factory overhead budget 75

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Selling and administrative expense budget Pro forma income statement The financial budget consists of:

■ ■

Cash budget Pro forma balance sheet The five major steps in preparing the budget are: 1. 2. 3. 4. 5.

Prepare a sales forecast. Determine expected production volume. Estimate manufacturing costs and operating expenses. Determine cash flow and other financial effects. Formulate projected financial statements.

Exhibit 6.1 presents a master budget.

Comprehensive Sales Planning Chapter 5 gave an overview of a comprehensive profit plan. The initiating management decisions in developing the plan were the statements of broad objectives, specific goals, basic strategies, and planning premises. The sales planning process is a necessary part of profit planning and control because (1) it provides for the basic management decisions about marketing, and (2) based on those decisions, it is an organized approach for developing a comprehensive sales plan. If the sales plan is not realistic, most if not all of the other parts of the overall profit plan also are not realistic. Therefore, if the management believes that a realistic sales plan cannot be developed, there is little justification for profit planning and control. Despite the views of a particular management, such a conclusion may be an implicit admission of incompetence. Simply, if it is really impossible to assess the future revenue potential of a business, there would be little incentive for investment in the business initially or for continuation of it except for purely speculative ventures that most managers and investors prefer to avoid. The primary purposes of a sales plan are (1) to reduce uncertainty about the future revenues, (2) to incorporate management judgments and decisions into the planning process (e.g., in the marketing plans), (3) to provide necessary information for developing other elements of a comprehensive profit plan, and (4) to facilitate management’s control of sales activities. Sales Planning Compared with Forecasting Sales planning and forecasting often are confused. Although related, they have distinctly different purposes. A forecast is not a plan; rather it is a statement and/

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Exhibit 6.1 Master Budget Sales Budget

Desired Ending Inventory Budget

Direct Material

Production Budget

Direct Labor

Factory Overhead

Cost of Goods Sold Budget

Selling Expense Budget

Administrative Expense Budget

Budgeted Income Statement

Capital Budget

Budgeted Balance Sheet

Cash Budget

or a quantified assessment of future conditions about a particular subject (e.g., sales revenue) based on one or more explicit assumptions. A forecast should always state the assumptions on which it is based. A forecast should be viewed as only one input into the development of a sales plan. The management of a company may accept, modify, or reject the forecast. In contrast, a sales plan incorporates management decisions that are based on the forecast, other inputs, and management judgments about such related items as sales volume, prices, sales effects, production, and financing. Testing the Top Line Most companies do not really manage top-line growth. They allocate resources to businesses they think will be most productive and hope the economy cooperates.

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But a growing number of companies are taking a less passive approach and studying revenue growth more carefully. They argue that quantifying the sources of revenue can yield a wealth of information, which results in more targeted and more effective decision-making. With the right discipline and analysis, they say, growing revenues can be as straightforward as cutting costs. Some companies go so far as to link the two efforts. The idea is to bring the same systematic analysis to growing revenue that we have brought to cost cutting. A sources-of-revenue statement (SRS) is useful in this effort. The information on revenue captured by traditional financial statements is woefully inadequate. Sorting revenues by geographic market, business unit, or product line tells the source of sales. But it does not explain the underlying reason for those sales. The SRS model breaks revenue into five categories: 1. 2. 3. 4. 5.

Continuing sales to established customers (known as base retention) Sales won from the competition (share gain) New sales from expanding markets Moves into adjacent markets where core capabilities can be leveraged Entirely new lines of business unrelated to the core

To produce an SRS statement, five steps are required in addition to establishing total revenues for comparable periods, as is commonly done for purposes of completing an income statement: 1. Determine revenue from the core business by establishing the revenue gain or loss from entry to or exit from adjacent markets and the revenue gain from new lines of business, and subtracting this from total revenue. 2. Determine growth attributable to market positioning by estimating the market growth rate for the current period and multiplying this by the prior period’s core revenue. 3. Determine the revenue not attributable to market growth by subtracting the amount determined in Step 2 from that determined in Step 1. 4. To calculate base retention revenue, estimate the customer churn rate, multiply it by the prior period’s core revenue, and deduct this from the prior period’s core revenue. 5. To determine revenue from market-share gain, subtract retention revenue, growth attributable to market positioning, and growth from new lines of business and from adjacent markets from core revenue. Example 1 To illustrate how all these budgets are put together, we will focus on a manufacturing company called the Putnam Company, which produces and markets a single product. We will make these assumptions:

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■ ■

■

/

79

The company uses a single material and one type of labor in the manufacture of the product. It prepares a master budget on a quarterly basis. Work-in-process inventories at the beginning and end of the year are negligible and are ignored. The company uses a single cost driver—direct labor hours (DLH)—as the allocation base for assigning all factory overhead costs to the product.

Sales Budget The sales budget is the starting point in preparing the master budget, since estimated sales volume influences nearly all other items appearing throughout the master budget. The sales budget should show total sales in quantity and value. The expected total sales can be break-even or target income sales or projected sales. It may be analyzed further by product, by territory, by customer, and, of course, by seasonal pattern of expected sales. Generally, the sales budget includes a computation of expected cash collections from credit sales, which will be used later for cash budgeting. Schedule 1 THE PUTNAM COMPANY Sales Budget For the Year Ended December 31, 20B Quarter 1 Expected sales in units* Unit sales price* Total sales

1,000 $150 $150,000

2

3

1,800 $150 $270,000

2,000 $150 $300,000

4 1,200 $150 $180,000

Year as a Whole 6,000 $150 $900,000

*Given

Schedule of Expected Cash Collections Accounts receivable, 12/31/20A 1st-quarter sales ($150,000) 2nd-quarter sales ($270,000) 3rd-quarter sales ($300,000) 4th-quarter sales ($180,000) Total cash collections

$100,000* 60,000†

$160,000

$90,000‡ 108,000

$198,000

$162,000 120,000 $282,000

$180,000 72,000 $252,000

$100,000 150,000 270,000 300,000 72,000 $892,000

*All of the $100,00 accounts receivable balance is assumed to be collectible in the first quarter. 40 percent of a quarter’s sales are collected in the quarter of sale. ‡ 60 percent of a quarter’s sales are collected in the quarter following. †

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Monthly Cash Collections from Customers Frequently there are time lags between monthly sales made on account and their related monthly cash collections. For example, in any month, credit sales are collected in this manner: 15 percent in month of sale, 60 percent in the following month, 24 percent in the month after, and the remaining 1 percent are uncollectible.

Credit sales

April—Actual

May—Actual

June—Budgeted

$320

200

300

July—Budgeted 280

The budgeted cash receipts for June and July are computed: For June: From April sales From May sales From June sales Total budgeted collections in June

$320 .24 200 .6 300 .15

$76.80 120.00 45.00 $241.80

For July: From May sales From June sales From July sales Total budgeted collections in July

$200 .24 300 .6 280 .15

$48 180 42 $270

Production Budget After sales are budgeted, the production budget can be determined. The production budget is a statement of the output by product and is generally expressed in units. It should take into account the sales budget, plant capacity, whether stocks are to be increased or decreased, and outside purchases. The number of units expected to be manufactured to meet budgeted sales and inventory requirements is set forth in the production budget. Expected production volume Planning sales Desired ending inventory Begining inventory

The production budget is illustrated in Schedule 2.

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Schedule 2 THE PUTNAM COMPANY Sales Budget For the Year Ended December 31, 20B Quarter 1 Planned Sales (SChedule 1) Desired ending inventory* Total needs Less: Beginning inventory Units to be produced

1,000 180 1,180 200† 980

2 1,800 200 2,000 180‡ 1,820

3

4

2,000 120 2,120 200 1,920

1,200 300 1,500 120 1,380

Year as a Whole 6,000 300 6,300 200 6,100

*10 percent of the next quarter’s sales ( for example, 180 10% 1,800). Given. ‡ The same as the previous quarter’s ending inventory. †

Inventory Purchases, Merchandising Firm Putnam Company is a manufacturing firm, so it prepares a production budget, as shown in Schedule 2. If the company were a merchandising (retailing or wholesaling) firm, then instead of a production budget, it would develop a merchandise purchase budget showing the amount of goods to be purchased from its suppliers during the period. The merchandise purchases budget is in the same basic format as the production budget, except that it shows goods to be purchased rather than goods to be produced: Budgeted cost of goods sold (in units or dollars) Add: Desired ending merchandise inventory Total needs Less: Beginning merchandise inventory Required purchases (in units or in dollars)*

$560,000** 120,000 $680,000 (80,000) $600,000

*Cost of goods sold beginning inventory purchases ending inventory. Hence, purchases cost of goods sold ending inventory beginning inventory **Gross profit (margin) sales cost of goods sold (or cost of sales). For example, percentagewise, 30% 100% 70%. For example, sales is $800,000, then the cost of goods sold is $800,000 70% $560,000

Direct Material Budget When the level of production has been computed, a direct material budget should be constructed to show how much material will be required for production and how much material must be purchased to meet this production requirement. The purchase will depend on both expected usage of materials and inventory levels. The formula for computation of the purchase is: Purchase in units Usage Desired ending material inventory units Beginning inventory units

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The direct material budget is usually accompanied by a computation of expected cash payments for materials. Schedule 3 THE PUTNAM COMPANY Sales Budget For the Year Ended December 31, 20B Quarter

Units to be produced (Sch.2) Material needs per unit (lbs)* Production needs (usage) Desired ending inventory of materials† Total needs Less: Beginning inventory of materials Materials to be purchased Unit price* Purchase cost

1

2

980 2 1,960 910 2,870 490† 2,380 $5 $11,900

1,820 2 3,640 960 4,600 910§ 3,690 $5 $18,450

3 1,920 2 3,840 690 4,530 960 3,570 $5 $17,850

4

Year as a Whole

1,380 2 2,760 520‡ 3,280 690 2,590 $5 $12,950

6,100 2 12,200 520 12,720 490 12,230 $5 $61,150

*Given. 25 percent of the next quarter’s units needed for production. For example, the 2nd-quarter production needs are 3,640 lbs. Therefore, the desired ending inventory for the 1st quarter would be 25% 3,640 lbs. 910 lbs. Also note: 490 lbs 25% 1,960 490 lbs. ‡ Assume that the budgeted production needs in lbs. for the 1st quarter of 20C 2,080 lbs. So, 25% 2,080 lbs. 520 lbs. § The same as the prior quarter’s ending inventory. †

Schedule of Expected Cash Collections Accounts payable, 12/31/20A 1st-quarter purchases ($11,900) 2nd-quarter purchases ($18,450) 3rd-quarter purchases ($17,850) 4th-quarter sales ($180,000) Total disbursements

$6,275* 5,950 5,950*†

$12,225

5,950† 9,225

$15,175

9,225 8,925 $18,150

8,925 6,475 $15,400

$6,275 11,900 18,450 17,850 6,475 $60,950

*All of the $6,275 accounts payable balance (from the balance sheet, 20A) is assumed to be paid in the first quarter. †50 percent of a quarter’s purchases are paid for in the quarter of purchase; the remaining 50 percent are paid for in the following quarter.

Direct Labor Budget The production requirements as set forth in the production budget also provide the starting point for the preparation of the direct labor budget. To compute direct labor requirements, expected production volume for each period is multiplied by the number of direct labor hours required to produce a single unit. The direct labor hours to meet production requirements is then multiplied by the (standard) direct labor cost per hour to obtain budgeted total direct labor costs.

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Schedule 4 THE PUTNAM COMPANY Direct Labor Budget For the Year Ended December 31, 20B Quarter

Units to be produced (Sch. 2) Direct labor hours per unit* Total hours Direct labor cost per hour* Total direct labor cost

1

2

3

4

Year as a Whole

980 5 4,900 $10 $49,000

1,820 5 9,100 $10 $91,000

1,920 5 9,600 $10 $96,000

1,380 5 6,900 $10 $69,000

6,100 5 30,500 $10 $305,000

*Both are given.

Factory Overhead Budget The factory overhead budget should provide a schedule of all manufacturing costs other than direct materials and direct labor. Using the contribution approach to budgeting requires the development of a predetermined overhead rate for the variable portion of the factory overhead. In developing the cash budget, we must remember that depreciation does not entail a cash outlay and therefore must be deducted from the total factory overhead in computing cash disbursement for factory overhead. Schedule 5 To illustrate the factory overhead budget, we will assume that ■

■ ■

Total factory overhead budgeted $18,300 fixed (per quarter), plus $2 per hour of direct labor. This is one example of a cost-volume (or flexible budget) formula (y a bx), developed via the least-squares method with a high R2. Depreciation expenses are $4,000 each quarter. Overhead costs involving cash outlays are paid for in the quarter incurred. THE PUTNAM COMPANY Factory Overhead Budget For the Year Ended December 31, 20B Quarter

Budgeted direct labor Variable overhead rate Variable overhead budgeted Fixed overhead budgeted Total budgeted overhead Less: Depreciation* Cash disbursements for Factory overhead

1

2

3

4

Year as a Whole

4,900 2 9,800 18,300 28,100 4,000 $24,100

9,100 2 18,200 18,300 36,500 4,000 $32,500

9,600 2 19,200 18,300 37,500 4,000 $33,500

6,900 2 13,800 18,300 32,100 4,000 $28,100

30,500 2 61,000 73,200 134,200 16,000 $118,200

*Depreciation does not require a cash outlay.

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Ending Finished Goods Inventory Budget The ending finished goods inventory budget provides us with the information required for the construction of budgeted financial statements. After completing Schedules 1 to 5, sufficient data will have been generated to compute the perunit manufacturing cost of finished product. This computation is required for two reasons: (1) to help compute the cost of goods sold on the budgeted income statement, and (2) to give the dollar value of the ending finished goods inventory to appear on the budgeted balance sheet.

Schedule 6 THE PUTNAM COMPANY Ending Inventory Budget For the Year Ended December 31, 20B Ending Inventory Units 300 units (Sch.2)

Unit Product Cost

Total

$82*

$24,600

*The unit product cost of $82 is computed as follows:

Direct materials Direct labor Factory overhead‡ Unit product cost

Unit Cost

Units

$5 per lbs. 10 per hr. 4.40 per hr.

2 pounds 5 hours 5 hours

Total $10 50 22 $82

‡ Predetermined factory overhead applied rate = budgeted annual factory overhead/budgeted annual activity units = $134,200/30,500 DLH = $4.40.

Selling and Administrative Expense Budget The selling and administrative expense budget lists the operating expenses involved in selling the products and in managing the business. Just as in the case of the factory overhead budget, this budget can be developed using the cost-volume (flexible budget) formula in the form of y a bx. If the number of expense items is very large, separate budgets may be needed for the selling and administrative functions.

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Schedule 7 THE PUTNAM COMPANY Selling and Administrative Expense Budget For the Year Ended December 31, 20B Quarter 1 Expected sales in units Variable selling and administrative expense per unit* Budgeted variable expense Fixed selling and administrative expense†: Advertising Insurance Office salaries Taxes Total budgeted selling and administrative expenses‡

2

3

4

Year as a Whole

1,000

1,800

2,000

12,000

6,000

3 $3,000

3 $5,400

3 $6,000

3 $3,200

3 $18,000

20,000

20,000

20,000

40,000

20,000 12,600 40,000

40,000

40,000 7,400

80,000 12,600 160,000 7,400

$63,000

$78,000

$66,000

$71,000

$278,000

*Assumed. It includes sales agents’ commissions, shipping, and supplies. Scheduled to be paid. ‡ Paid for in the quarter incurred. †

Cash Budget The cash budget is prepared for the purpose of cash planning and control. It presents the expected cash inflow and outflow for a designated time period. The cash budget helps management keep cash balances in reasonable relationship to its needs. It aids in avoiding unnecessary idle cash and possible cash shortages. The cash budget consists typically of five major sections: 1. The cash receipts section, which is cash collections from customers and other cash receipts, such as royalty income and investment income. 2. The cash disbursements section, which comprises all cash payments made by purpose. 3. The cash surplus or deficit section, which simply shows the difference between the total cash available and the total cash needed including a minimum cash balance if required. If there is surplus cash, loans may be repaid or temporary investments made.

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4. The financing section, which provides a detailed account of the borrowings, repayments, and interest payments expected during the budgeting period. 5. The investments section, which encompasses investment of excess cash and liquidation of investment of surplus cash.

Schedule 8 To illustrate, we will make these assumptions: ■

■

■

■ ■

■

Putnam Company has an open line of credit with its bank, which can be used as needed to bolster the cash position. The company desires to maintain a $10,000 minimum cash balance at the end of each quarter. Therefore, borrowing must be sufficient to cover the cash shortfall and to provide for the minimum cash balance of $10,000. All borrowings and repayments must be in multiples of $1,000 amounts, and interest is 10 percent per annum. Interest is computed and paid on the principal as the principal is repaid. All borrowings take place at the beginning of a quarter, and all repayments are made at the end of a quarter. No investment option is allowed in this example. The loan is self-liquidating in the sense that the borrowed money is used to obtain resources that are combined for sale, and the proceeds from sales are used to pay back the loan.

Note: To be useful for cash planning and control, the cash budget must be prepared on a monthly basis. Note also: Cash balance, beginning Add receipts: Total cash available before financing (a) Deduct disbursements: Total cash disbursements (b) Minimum cash balance desired Total cash needed (c) Cash surplus or deficit (a) 2 (c) Financing: Borrowing (at beginning) Repayment (at end) Interest Total effects of financing (d) Cash balance, ending [(a) (b) (d)]

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THE PUTNAM COMPANY Cash Budget For the Year Ended December 31, 20B Quarter From Schedule Expected sales in units Add: Receipts: Collections from customers Total cash available (a) Less: Disbursements: Direct materials Direct labor Factory overhead Selling and admin. Equipment purchase Dividends Income tax Total disbursements (b) Minimum cash balance Total cash needed (c) Cash surplus (deficit) (a) (c) Finance: Borrowing Repayment Interest Total effect of financing (d) Cash balance, ending [(a) (b) (d)]

1

1

3 4 5 7 Given Given 10

2

3

4

Year as a Whole

$19,000*

10,675

10,000

10,350

19,000

160,000 179,000

198,000 208,675

282,000 292,000

252,000 262,350

892,000 911,000

12,225 49,000 24,100 63,000 30,000 5,000 15,000 198,325 10,000 208,325

15,175 91,000 32,500 78,000 12,000 5,000 15,000 248,675 10,000 258,675

18,150 96,000 33,500 66,000 0 5,000 15,000 233,650 10,000 243,650

15,400 69,000 28,100 71,000 0 5,000 15,000 203,500 10,000 213,500

60,950 305,000 118,200 278,000 42,000 20,000 60,000 884,150 10,000 894,150

(29,325)

(50,000)

48,350

48,850

16,850

30,000† 0 0 30,000

50,000 0 0 50,000

$10,675

$10,000

0 0 (45,000) (35,000) (3,000)‡ (2,625)§ (48,000) (37,625)

80,000 (80,000) (5,625) (5,625)

$10,350

$21,225

$21,225

*$19,000(from balance sheet 20A). † The company desires to maintain a $10,000 minimum cash balance at the end of each quarter. Therefore, borrowing must be sufficient to cover the cash shortfall of $19,325 and to provide for the minimum cash balance of $10,000, for a total of $29,325. ‡ The interest payments relate only to the principal being repaid at the time it is repaid. For example, the interest in quarter 3 relates only to the interest due on the $30,000 principal being repaid from quarter 1 borrowing and on the $15,000 principal being repaid from quarter 2 borrowing. Total interest being paid is $3,000, shown as: $30,000 10% 3/4 $2,250 $15,000 10% 2/4 750 § $35,000 10% 3/4 $2,625

Budgeted Income Statement The budgeted income statement summarizes the various component projections of revenue and expenses for the budgeting period. However, for control purposes, the budget can be divided into quarters or even months, depending on the need.

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Schedule 9 THE PUTNAM COMPANY Budgeted Income Statement For the Year Ended December 31, 20B From Schedule Sales (6,000 units @$150) Less: Cost of goods sold: Beginning finished goods inventory Add: Cost of goods manufactured (6,100 units @$82) Cost of goods available for sale Less: Ending finished goods inventory Gross margin Less: Selling and administrative expense Operating income Less: Interest expense Net income before taxes Less: income taxes Net income after taxes

$900,000 10 6 6 7 8

$16,400 500,200 516,600 (24,600)

$492,000 $408,000 278,000 130,000 5,625 124,375 60,000* $ 64,375

*Estimated.

Budgeted Balance Sheet The budgeted balance sheet is developed by beginning with the balance sheet for the year just ended and adjusting it, using all the activities that are expected to take place during the budgeting period. Some of the reasons why the budgeted balance sheet must be prepared are: ■

■ ■ ■

It could disclose some unfavorable financial conditions that management might want to avoid. It serves as a final check on the mathematical accuracy of all the other schedules. It helps management perform a variety of ratio calculations. It highlights future resources and obligations. We can construct the budgeted balance sheet by using:

■ ■ ■

The December 20A balance sheet (Schedule 10) The cash budget (Schedule 8) The budgeted income statement (Schedule 9)

Putnam’s budgeted balance sheet for December 31, 20B, is presented next. Supporting calculations of the individual statement accounts are also provided.

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Schedule 10 To illustrate, we will use this balance sheet for the year 20A. THE PUTNAM COMPANY Balance Sheet December 31, 20A Assets Current assets: Cash Accounts receivable Materials inventory (490 lbs.) Finished goods inventory (200 units) Total current assets Plant and equipment: Land Building and equipment Accumulated depreciation Plant and equipment, net Total assets

$19,000 100,000 2,450 16,400 $137,850 30,000 250,000 (74,000) 206,000 $343,850

Liabillities and Stockholders’ Equity Current liabilities Accounts payable (raw materials) Income tax payable Total current liabilities Stockholders’ equity: Common stock, no par Retained earnings Total stockholders’ equity Total liabilities and stockholders’ equity

$6,275 60,000 $66,275 $200,000 77,575 277,575 $343,850

THE PUTNAM COMPANY Balance Sheet December 31, 20B Assets Cash Accounts receivable Materials inventory (520 lbs.) Finished goods inventory (300 units) Total current assets Plant and equipment: Land Buildings and equipment Accumulated depreciation Plant and equipment, net Total assets

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$21,225 108,000 2,600 24,600

(a) (b) (c) (d) $156,425

30,000 (e) 292,000 (f) (90,000) (g) 232.000 $388,425

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Budgeting Basics and Beyond Liabilities and Stockholders’ Equity Current liabilities Accounts payable (raw materials) Income tax payable Total current liabilities Stockholders’ equity: Common stock, no par Retained earnings Total stockholders’ equity Total liabilities and stockholders’ equity

$6,475 (h) 60,000 (i) $66,475 $200,000 (j) 121,950 (k) 321,950 $388,425

Supporting computations: a. From Schedule 8 (cash budget). b. $100,000 (Accounts receivable, 12/31/20A) $900,000 (Credit sales from Schedule 1) $892,000 (Collections from Schedule 1) $108,000, or 60% of 4th-quarter credit sales, from Schedule 1 ($180,000 60% $108,000). c. Direct materials, ending inventory 520 pounds $5 $2,600 (From Schedule 3). d. From Schedule 6 (ending finished goods inventory budget). e. From the 20A balance sheet and Schedule 8 (no change). f. $250,000 (Building and Equipment, 12/31/20A) $42,000 (purchases from Schedule 8) $292,000. g. $74,000 (Accumulated Depreciation, 12/31/20A) $16,000 (depreciation expense from Schedule 5) $90,000. h. Note that all accounts payable relate to material purchases. $6,275 (Accounts payable, 12/31/20A) $61,150 (credit purchases from Schedule 3) $60,950 (payments for purchases from Schedule 3) $6,475, or 50% of 4th-quarter purchase 50% ($12,950) $6,475. i. From Schedule 9. j. From the 20A balance sheet and Schedule 8 (no change). k. $77,575 (Retained earnings, 12/31/20A) $64,375 (net income for the period, Schedule 9) $20,000 (cash dividends from Schedule 8) $121,950.

Some Financial Calculations To see what kind of financial condition the Putnam Company is expected to be in for the budgeting year, a sample of financial ratio calculations are in order. (Assume 20A after-tax net income was $45,000.) Current ratio (Current assets/current liabilities) Return on total assets: (Net income after taxes/ total assets)

20A

20B

$137,850/$66,275 2.08

$156,425/$66,475 2.35

$45,000/$343,850 13.08%

$64,375/$388,425 16.57%

Sample calculations indicate that the Putnam Company is expected to have better liquidity as measured by the current ratio. Overall performance will be improved as measured by return on total assets. This could be an indication that the contemplated plan may work out well.

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Using an Electronic Spreadsheet to Develop a Budget Plan Schedules 1 to 10 showed a detailed procedure for formulating a master budget. In practice, a common shortcut uses computer technology. With a spreadsheet program, managers will be able to develop a master budget and evaluate various “what-if ” scenarios.

Financial Forecasting — The Percent-of- Sales Method Financial forecasting, an essential element of planning, is the basis for budgeting activities. It is also needed when estimating future financing requirements. The company may look either internally or externally for financing. Internal financing refers to cash flow generated by the company’s normal operating activities. External financing refers to capital provided by parties external to the company. You need to analyze how to estimate external financing requirements. Basically, forecasts of future sales and related expenses provide the firm with the information to project future external financing needs. The basic steps in projecting financing needs are: 1. Project the firm’s sales. The sales forecast is the initial most important step. Most other forecasts (budgets) follow the sales forecast. 2. Project additional variables such as expenses. 3. Estimate the level of investment in current and fixed assets required to support the projected sales. 4. Calculate the firm’s financing needs. The most widely used method for projecting the company’s financing needs is the percent-of-sales method. This method involves estimating the various expenses, assets, and liabilities for a future period as a percent of the sales forecast and then using these percentages, together with the projected sales, to construct forecasted balance sheets. The following example illustrates how to develop a pro forma balance sheet and determine the amount of external financing needed. Example 2 Assume that sales for 20X0 $20, projected sales for 20X1 $24, net income 5% of sales, and the dividend payout ratio 40%. Schedule 11 illustrates the method, step by step. All dollar amounts are in millions. The steps for the computations are outlined as follows: Step 1. Express those balance sheet items that vary directly with sales as a percentage of sales. Any item such as long-term debt that does not vary directly with sales is designated “n.a.,” or “not applicable.”

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Step 2. Multiply these percentages by the 20X1 projected sales = $24 to obtain the projected amounts as shown in the last column. Step 3. Simply insert figures for long-term debt, common stock and paid-incapital from the 19X1 balance sheet. Step 4. Compute 20X1 retained earnings as shown in (b). Step 5. Sum the asset accounts, obtaining a total projected assets of $7.2, and also add the projected liabilities and equity to obtain $7.12, the total financing provided. Since liabilities and equity must total $7.2, but only $7.12 is projected, we have a shortfall of $0.08 “external financing needed.” The major advantage of the percent-of-sales method of financial forecasting is that it is simple and inexpensive to use. One important assumption behind the use of the method is that the firm is operating at full capacity. This means that the company has no sufficient productive capacity to absorb a projected increase in sales and thus requires additional investment in assets. Therefore, the method must be used with extreme caution if excess capacity exists in certain asset accounts. To obtain a more precise projection of the firm’s future financing needs, however, the preparation of a cash budget (to be discussed later in detail in Chapter 17) is required. Schedule 11 PRO FORMA BALANCE SHEET IN MILLIONS OF DOLLARS % of Sales (200 Sales $20)

Projected (201 Sales $24)

2 4 6

10 20

2.4 4.8 7.2

2 2.5 4.5

10 n.a.

2.4 2.5 4.9

0.1 0.2 1.2 1.5

n.a. n.a.

0.1 0.2 1.92 2.22

Present (200) Assets Current assets Fixed assets Total assets Liabilities and Stockholders’ Equity Current liabilities Long-term debt Total liabilities Common stock Paid-in-capital Retained earnings Total equity Total liabilities and stockholders’ eqty

6

7.12 0.08 7.2

1

Total financing provided External financing needed2 Total

20X1 retained earnings = 20X0 retained earnings projected net income cash dividends paid $1.2 5%($24) 40%[5%($24)] $1.2 $1.2 $0.48 $2.4 $0.48 $1.92 2 External financing needed projected total assets (projected total liabilities projected equity) = $7.2 ($4.9 + $2.22) = $7.2 $7.12 = $0.08 1

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Conclusion Forecasting is an essential element of planning and budgeting. Forecasts of future sales and their related expenses provide managers with information needed to plan other activities of the business. This chapter has emphasized budgets. The process involves developing a sales forecast and, based on its magnitude, generating those budgets needed by a specific firm. Once developed, the budgeting system provides nonfinancial management with a means of controlling their activities and of monitoring actual performance and comparing it to budget goals. Budgeting can be done easily with the aid of electronic spreadsheet software. Many specialized application programs are available.

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7 Cost Behavior Emphasis on Flexible Budgets

N

ot all costs behave in the same way. Certain costs vary in proportion to changes in volume or activity, such as labor hours and machine hours. Other costs do not change, even though volume changes. An understanding of cost behavior is helpful to managers for four reasons: 1. 2. 3. 4.

Flexible budgeting Break-even and contribution margin analysis Appraisal of divisional performance Short-term choice decisions

A Look at Costs by Behavior Depending on how a cost will react or respond to changes in the level of activity, costs may be viewed as variable, fixed, or mixed (semivarible). This classification is made within a specified range of activity, called the relevant range. The relevant range is the volume zone within which the behavior of variable costs, fixed costs, and selling prices can be predicted with reasonable accuracy. Variable Costs Variable costs vary in total with changes in volume or level of activity. Examples of variable costs include the costs of direct materials, direct labor, and sales commissions. These factory overhead items fall into the variable cost category: Variable Factory Overhead Supplies Fuel and power Spoilage and defective work

Receiving costs Overtime premium

95

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Fixed Costs Fixed costs do not change in total regardless of the volume or level of activity. Examples include advertising expense, salaries, and depreciation. These factory overhead items fall in the fixed cost category: Fixed Factory Overhead Property taxes Depreciation Insurance

Rent on factory building Indirect labor Patent amortization

Mixed (Semivariable) Costs Mixed costs contain both a fixed element and a variable one. Salespersons’ compensation, including salary and commission, is an example. These factory overhead items may be considered mixed costs: Mixed Factory Overhead Supervision Inspection Service department costs Utilities Fringe benefits

Maintenance and repairs Compensation insurance Employer ’s payroll taxes Rental of delivery truck

Note that factory overhead, taken as a whole, would be a perfect example of mixed costs. Exhibit 7.1 displays how each of these three types of costs varies with changes in volume.

Analysis of Mixed (Semivariable) Costs For forecasting, planning, and budgeting, mixed costs need to be separated into their variable and fixed components. Because the mixed costs contain both fixed and variable elements, the analysis takes this mathematical form, which is called a cost-volume formula (or flexible budget formula): Y a bX Where Y the mixed cost to be broken up X any given measure of activity such as direct labor hours, machine hours, or production volume a the fixed cost component b the variable rate per unit of X

Separating the mixed cost into its fixed and variable components is the same thing as estimating the parameter values a and b in the Y a bX formula. Several methods can be used for this purpose, including the high-low method and regression analysis. They are discussed next.

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Exhibit 7.1 Cost Behavior Patterns

Dollars (y)

Variable Costs

Semivariable Costs

Fixed Costs

Volume or Level of Activity (x)

High-low Method The high-low method, as the name indicates, uses two extreme data points to determine the values of a (the fixed cost portion) and b (the variable rate) in the equation Y a bX. The extreme data points are the highest representative X Y pair and the lowest representative X Y pair. The activity level X, rather than the mixed cost item y, governs their selection. The high-low method is explained, step by step: Step 1: Select the highest pair and the lowest pair. Step 2: Compute the variable rate, b, using the formula: Difference in cost y Variable rate ________________ Difference in activity x

Step 3: Compute the fixed cost portion as: Fixed cost portion Total mixed cost – Variable cost

Example 1 Flexible Manufacturing Company decided to relate total factory overhead costs to direct labor hours (DLH) to develop a cost function in the form of Y a bX. Twelve monthly observations are collected. They are given in Exhibit 7.2.

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Exhibit 7.2 Direct Labor/Factory Overhead Table

Month

Direct Labor Hours (X)

Factory Overhead (Y)

105 100 88 116 95 107 97 110 135 115 117 96

$2,510 2,479 2,080 2,750 2,330 2,690 2,480 2,610 2,920 2,730 2,760 2,109

January February March April May June July August September October November December

The high-low method is simple and easy to use. It has the disadvantage, however, of using two extreme data points, which may not be representative of normal conditions. The method may yield unreliable estimates of a and b in the formula. In this example, the negative value for a is questionable. In such a case, it would be wise to drop these data points and choose two other points that are more representative of normal situations. Be sure to check the scatter diagram for this possibility. The high-low points selected from the monthly observations are X High Low Difference

135 hours 88 47 hours

Y $2,920 (September pair) 2,080 (March pair) $ 840

$840 Difference in Y Variable b ___________ ______ $17.8723 per DLH Difference in X 47 hours

The fixed cost portion is computed as: High Factory overhead (Y) Variable expense ($17.8723 per DLH)

$2,920 (2,412.76)* 507.234

Low $2,080 (1,572.76)* 507.234

*$17.8723 135 hours $2412.76; $17.8723 88 hours $1572.76

Therefore, the flexible budget formula for factory overhead is $507.234 fixed plus $17.8723 per DLH.

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Regression Analysis One popular method for estimating the cost function is regression analysis. Unlike the high-low method, in an effort to estimate the variable rate and the fixed cost portion, the regression method includes all the observed data and attempts to find a line of best fit (refer to Chapter 16 for detailed treatment). From the regression output of Excel (see Exhibit 7.3), the flexible budget formula is Y 566.02 18.47 X with R2 82.58% or $566.02 fixed, plus $18.47 per DLH

Note: R2 tells us how good the estimated regression equation is. In other words, it is a measure of “goodness of fit” in the regression. Therefore, the higher the R2, the more confidence we have in our flexible budget formula. Example 2 Assume 95 direct labor hours are to be expended next year. The projected factory overhead for next year would be computed as: Y 566.02 18.47 X 566.02 18.47 (95) $566.02 $1754.65 $2320.67

Exhibit 7.3 Summary Output Regression Statistics Multiple R R-Squared Adjusted R-Squared Standard Error Observations

0.9087524 0.825831 0.808414 114.29182 12

ANOVA

Regression Residual Total

Intercept Direct labor hours (x)

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df

SS

1 10 11

619370.4611 130626.2056 749996.6667

Coefficients

Standard Error

566.02156 18.466621

288.1776914 2.681805902

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Fixed Budgets versus Flexible Budgets and Performance Reports A fixed (static) budget presents budgeted amounts at the expected capacity level. It is best used when the department’s activities (e.g., sales) are stable. A deficiency with the static budget is the lack of flexibility to adjust to unexpected changes. The fixed budget is suitable for a department whose workload does not have a direct relationship to sales, production, or other volume related to a department’s operations. The workload is determined primarily by management decision instead of sales volume. Some examples of departments in this category are administrative and marketing. Fixed budgets may be used for projects involving fixed appropriations for specific programs, such as capital expenditures, advertising and promotion, and major repairs. A flexible budget is a tool that is extremely useful in cost control. In contrast to a static budget, the flexible budget ■ ■

Is geared toward a range of activity rather than a single level of activity Is dynamic in nature rather than static. By using the flexible budget formula, a series of budgets can be easily developed for various levels of activity. Four steps are involved in creating a flexible budget: 1. Estimate the range of expected activity for the period. 2. Analyze cost behavior trends, whether fixed, variable, or mixed. 3. Separate costs by behavior, that is, break up mixed costs into variable and fixed. 4. Determine what costs will be incurred at different levels of activity.

The static (fixed) budget is geared for only one level of activity and has problems in cost control. Flexible budgeting distinguishes between fixed and variable costs, thus allowing for a budget that can be adjusted automatically (via changes in variable cost totals) to the particular level of activity actually attained. Thus, variances between actual costs and budgeted costs are adjusted for volume ups and downs before differences due to price and quantity factors are computed. The primary use of the flexible budget is to accurately measure performance by comparing actual costs for a given output with the budgeted costs for the same level of output. Note: A flexible budget is appropriate for marketing budgets as well as for manufacturing cost budgets. Example 3 To illustrate the difference between the static budget and the flexible budget, assume that the Assembly Department of Omnis Industries, Inc., was budgeted to produce 6,000 units during June. Assume further that the company was able

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to produce only 5,800 units. The budget for direct labor and variable overhead costs is: OMNIS INDUSTRIES, INC. The Direct Labor and Variable Overhead Budget Assembly Department For the Month of June Budgeted production Actual production

6,000 units 5,800 units

Direct labor Variable overhead costs: Indirect labor Supplies Repairs

$39,000 6,000 900 300 $46,200

If a static budget approach is used, the performance report will appear in this way: OMNIS INDUSTRIES, INC. Direct Labor and Variable Overhead Static Budget Versus Actual Assembly Department For the Month of June

Production in units Direct labor Variable overhead costs: Indirect labor Supplies Repairs

Budget

Actual*

6,000

5,800

200U

$39,000

$38,500

$500F

6,000 900 300 $46,200

5,950 870 295 $45,615

50F 30F 5F $585F

Variance (U or F)†

*Given. †

A Variance represents the deviation of actual cost from the standard or budgeted cost. U and F stand for “unfavorable” and “favorable,” respectively.

These cost variances are useless, in that they are comparing oranges with apples. The problem is that the budget costs are based on an activity level of 6,000 units, whereas the actual costs were incurred at an activity level below this (5,800 units). From a control standpoint, it makes no sense to try to compare costs at one activity level with costs at a different activity level. Such comparisons would make a production manager look good as long as the actual production is less than the budgeted production. Using the flexible budget formula and generating the budget based on the 5,800 actual units gives the next performance report.

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Budgeting Basics and Beyond OMNIS INDUSTRIES, INC. Performance Report Assembly Department Flexible Budget Versus Actual For the Month of June

Budgeted production Actual production

Direct labor Variable overhead: Indirect labor Supplies Repairs

6,000 units 5,800 units Flexible Budget formula

Flexible Budget 5,800 units

Actual 5,800 units

Variance (U or F)

$6.50 per unit

$37,700

$38,500

$800U

1.00 0.15 0.05 $7.70

5,800 870 290 $44,660

5,950 870 295 $45,615

150U 0 5U $955U

Notice that all cost variances are unfavorable (U), as compared to the favorable cost variances on the performance report based on the static budget approach. Example 4 (Budgeting for a Healthcare Provider) Exhibit 7.4 illustrates a static budget, Exhibit 7.5 presents a flexible budget, and Exhibit 7.6 illustrates a performance report showing variances. Exhibit 7.4 X-Ray Unit Medical Service Corporation Performance Report–Static Budget May 20X2 Master Budget Units Sales revenue Variable costs: Film Other material Technician Other labor Other variable Total variable Contribution margin Fixed costs: Rent Depreciation Supervision Other fixed Total fixed Operating income

Actual

Variance

2,000 $60,000

1,200 $36,000

800 $24,000*

16,000 4,000 3,000 900 2,400 26,300 33,700

11,500 3,000 2,500 600 2,000 19,600 16,400

4,500 1,000 500 300 400 6,700 17,300*

800 400 2,000 3,500 6,700 27,000

800 400 2,000 3,300 6,500 9,900

0 0 0 200 200 17,100*

*Unfavorable. Favorable.

+

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Exhibit 7.5 X-Ray Unit Medical Service Corporation Flexible Budget May 20X2

Sales revenue Variable costs: Film Other material Technician Other labor Other variable Total variable costs Contribution margin Fixed costs: Rent Depreciation Supervision Other fixed Total fixed costs Operation income

Number of X-rays per Month

Budgeted per unit

1,000

1,200

1,400

1,800

2,000

$30.00

$30,000

$36,000

$42,000

$54,000

$60,000

8.00 2.00 1.50 0.45 1.20 13.15 16.85

8,000 2,000 1,500 450 1,200 13,150 16,850

9,600 2,400 1,800 540 1,440 15,780 20,220

11,200 2,800 2,100 630 1,680 18,410 23,590

14,400 3,600 2,700 810 2,160 23,670 30,330

16,000 4,000 3,000 900 2,400 26,300 33,700

800 400 2,000 3,500 6,700 10,150

800 400 2,000 3,500 6,700 13,520

800 400 2,000 3,500 6,700 16,890

800 400 2,000 3,500 6,700 23,630

800 400 2,000 3,500 6,700 27,000

Exhibit 7.6 X-Ray Unit Medical Service Corporation Performance Report–Flexible Budget May 20X2 Units Units Sales revenue Variable costs: Film Other material Technician Other labor Other variable Total variable costs Contribution margin Fixed costs: Rent Depreciation Supervision Other fixed Total fixed costs Operation income

Costs Incurred

Flexible budget

Variance Explanation

1,200 $36,000

1,200 $36,000

11,500 3,000 2,500 600 2,000 9,600 16,400

9,600 2,400 1,800 540 1,440 15,780 20,220

1,900* 600* 700* 60* 560* 3,820* 3,820*

800 400 2,000 3,300 6,500 9,900

800 400 2,000 3,500 6,700 13,520

0 0 0 200 200 3,620*

0 0

*Unfavorable. +

Favorable.

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Conclusion Nonfinancial managers must investigate cost behavior for break-even and costvolume-profit analysis, for appraisal of managerial performance, and for flexible budgeting. We have looked at three types of cost behavior—variable, fixed, and mixed. We illustrated two popular methods of separating mixed costs in their variable and fixed components: the high-low method and regression analysis. Emphasis was placed on the use of simple regression. The idea of flexible budgeting was emphasized in an attempt to correctly measure the efficiency of the cost center (e.g., assembly department).

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8 Evaluating Performance The Use of Variance Analysis

A

standard cost is a predetermined cost of manufacturing, servicing, or marketing an item during a given future period. It is based on current and projected future conditions. The norm is also dependent on quantitative and qualitative measurements. Standards may be based on engineering studies looking at time and motion. The formulated standard must be accurate and useful for control purposes. Standards are set at the beginning of the period. They may be in physical and dollar terms. Standards assist in the measurement of both effectiveness and efficiency. Examples are sales quotas, standard costs (e.g., material price, wage rate), and standard volume. Variances are not independent, so a favorable variance in one responsibility area may result in an unfavorable one in other segments of the business. Variance analysis compares standard to actual performance. It could be done by division, department, program, product, territory, or any other responsibility unit. When more than one department is used in a production process, individual standards should be developed for each department in order to assign accountability to department managers. Variances may be as detailed as necessary, considering the cost/benefit relationship. Evaluation of variances may be done yearly, quarterly, monthly, daily, or hourly, depending on the importance of identifying a problem quickly. Because actual figures (e.g., hours spent) are not known until the end of the period, variances can be determined only at this time. A material variance requires notifying the person responsible and taking corrective action. Insignificant variances need not be looked into further unless they recur repeatedly and/or reflect potential difficulty. Generally, a variance should be investigated when the inquiry is anticipated to result in corrective action that will reduce costs by an amount exceeding the cost of the inquiry. When the production cycle is long, variances that are computed at the time of product completion may be too late for prompt corrective action to be taken.

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In such a case, inspection may be undertaken at key points during the processing stage. This allows for spoilage, labor inefficiency, and other costs associated with problems to be recognized before product completion. One measure of materiality is to divide the variance by the standard cost. A variance of less than 5 percent may be deemed immaterial. A 10 percent variation may be more acceptable to a company using tight standards compared to a 5 percent variation to a company employing loose standards. In some cases, materiality is looked at in terms of dollar amount or volume level. For example, a company may set a policy looking into any variance that exceeds $10,000 or 20,000 units, whichever is less. Guidelines for materiality also depend on the nature of the particular element as it affects performance and decision-making. For example, where the item is critical to the future functioning of the business (e.g., critical part, promotion, repairs), limits for materiality should be such that reporting is encouraged. Further, statistical techniques can be used to ascertain the significance of cost and revenue variances. An acceptable range of tolerance should be established for managers (e.g., percent). Even if a variance never exceeds a minimum allowable percentage or minimum dollar amount, the manager may want to bring it to upper management’s attention if the variance is consistently close to the prescribed limit each year. This may indicate the standard is out of date and proper adjustment to current levels is mandated to improve overall profit planning. Because of the critical nature of costs, such as advertising and maintenance, materiality guidelines are more stringent. Often the reasons for the variance are out-of-date standards or a poor budgetary process and not actual performance. By questioning the variances and trying to find answers, the manager can make the operation more efficient and less costly. It must be understood, however, that quality should be maintained. If a variance is out of the manager ’s control, follow-up action by the manager is not possible. For example, utility rates are not controllable internally. Standards may change at different operational volume levels. Further, standards should be appraised periodically, and when they no longer realistically reflect conditions, they should be modified. Standards may not be realistic any longer because of internal events, such as product design, or external conditions, such as management and competitive changes. For instance, standards should be revised when prices, material specifications, product designs, labor rates, labor efficiency, and production methods change to such a degree that current standards no longer provide a useful measure of performance. Changes in the methods or channels of distribution, or basic organizational or functional changes, would require changes in selling and administrative activities. Significant favorable variances should also be investigated and should be taken advantage of further. Those responsible for good performance should be rewarded. Regression analysis may provide reliable association between costs and revenue.

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Evaluating Performance

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Variances are interrelated, and hence the net effect has to be examined. For example, a favorable price variance may arise when lower-quality materials are bought at a cheaper price, but the quantity variance will be unfavorable because of more production time to manufacture the goods due to poor material quality. In the case of automated manufacturing facilities, standard cost information can be integrated with the computer that directs operations. Variances can then be identified and reported by the computer system and necessary adjustments made as the operation proceeds. In appraising variances, consideration should be given to information that may have been, for whatever reason, omitted from the reports. Have there been changes in the production processes that have not been reflected in the reports? Have new product lines increased setup times that necessitate changes in the standards?

Usefulness of Variance Analysis Standards and variance analyses resulting from them are essential in financial analysis and decision making.

Advantages of Standards and Variances ■ ■ ■ ■ ■ ■

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Aid in inventory costing Assist in decision making Sell price formulation based on what costs should be Aid in coordinating by having all departments focus on common goals Set and evaluate divisional objectives Allow cost control and performance evaluation by comparing actual to budgeted figures. The objective of cost control is to produce an item at the lowest possible cost according to predetermined quality standards. Highlight problem areas through the “management by exception” principle Pinpoint responsibility for undesirable performance so that corrective action may be taken. Variances in product activity (cost, quality, quantity) are typically the production manager ’s responsibility. Variances in sales orders and market share are often the responsibility of the marketing manager. Variances in prices and methods of deliveries are the responsibility of purchasing personnel. Variances in profit usually relate to overall operations. Variances in return on investment relate to asset utilization. Motivate employees to accomplish predetermined goals Facilitate communication within the organization, such as between top management and supervisors Assist in planning by forecasting needs (e.g., cash requirements) Establish bid prices on contracts

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Standard costing is not without some drawbacks, such as the possible biases in deriving standards and the dysfunctional effects of establishing improper norms and standards. When a variance has multiple causes, each cause should be cited.

Standard Setting Standards may be set by engineers, production managers, purchasing managers, and personnel administrators. Depending on the nature of the cost item, computerized models can be used to corroborate what the standard costs should be. Standards may be established through test runs or mathematical and technological analysis. Standards are based on the particular situation being appraised. Some examples: Situation Cost reduction Pricing policy High-quality goods

Standards Tight Realistic Perfection

Capacity may be expressed in units, weight, size, dollars, selling price, and direct labor hours. It may be expressed in different time periods (e.g., weekly, monthly, yearly). Types of Standards ■

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Basic. These are not changed from period to period and are used in the same way as an index number. They form the basis to which later period performance is compared. What is unrealistic about basic standards is that no consideration is given to a change in the environment. Maximum efficiency. These are perfect standards assuming ideal, optimal conditions, allowing for no losses of any kind, even those considered unavoidable. They will always result in unfavorable variances. Realistically, certain inefficiencies will occur, such as materials will not always arrive at workstations on time and tools will break. Ideal standards cannot be used in forecasting and planning because they do not provide for normal inefficiencies. Currently attainable (practical). These refer to the volume of output possible if a facility operated continuously, but after allowing for normal and unavoidable losses such as vacations, holidays, and repairs. Currently attainable standards are based on efficient activity. They are possible but difficult to achieve. Considered are normal occurrences such as anticipated machinery failure and normal materials shortage. Practical standards should be set high enough to motivate employees and low enough to permit normal interruptions. Besides pointing to abnormal deviations in costs, practical standards may be used in

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forecasting cash flows and in planning inventory. Attainable standards typically are used in practice. Expected. These are expected figures based on foreseeable operating conditions and costs. They come very close to actual figures.

Standards should be set at a realistic level. Those affected by the standards should participate in formalizing them so there will be internalization of goals. When reasonable standards exist, employees typically become cost conscious and try to accomplish the best results at the least cost. Standards that are too tight will discourage employee performance. Standards that are too loose will result in inefficient operations. If employees receive bonuses for exceeding normal standards, the standards may be even more effective as motivation tools. A standard is not an absolute and precise figure. Realistically, a standard constitutes a range of possible acceptable results. Thus, variances can and do occur within a normal upper-lower limit. In determining tolerance limits, relative magnitudes are more important than absolute values. For instance, if the standard cost for an activity is $100,000, a plus or minus range of $4,000 may be tolerable. Variance analysis usually is complicated by the problem of computing the number of equivalent units of production. Variances may be controllable, partly controllable, or uncontrollable. It is not always easy to assign responsibility, even in the case of controllable variances. The extent to which a variance is controllable depends on the nature of the standard, the cost involved, and the particular factors causing the variance.

Planning Variance The planning variance arises when expected industry or other environmental factors do not materialize. For example, at the beginning of the period, the sales projection may be based on reviewing supply and demand. However, because of actual conditions in the industry, the actual sales may be much less. This sales unit variance may then be deemed a planning error and not a performance problem. Industry sales typically are considered beyond manager control.

Sales Variances Sales standards may be established to control and measure the effectiveness of the marketing operations as well as for other relevant purposes such as stimulating sales, reallocating sales, resources, and providing incentive awards. The usual standard set for a salesperson, branch, or territory is a sales quota. Although the sales quota typically is expressed in dollars, it may also be expressed in volume. Other types of standards that may be set to evaluate sales efforts are number of calls, order size, gross profit obtained, new customers obtained, and number of regular customers retained. Sales variances are computed to gauge the performance of the marketing function.

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Example 1 Western Corporation’s budgeted sales for 20X1 were Product A 10,000 units at $6.00 per unit Product B 30,000 units at $8.00 per unit Expected sales revenue

$ 60,000 240,000 $300,000

Actual sales for the year were Product A 8,000 units at $6.20 per unit Product B 33,000 units at $7.70 per unit Actual sales revenue

$ 49,600 254,100 $303,700

There is a favorable sales variance of $3,700, consisting of the sales price variance and the sales volume variance. The sales price variance equals (Actual Selling Price versus Budgeted Selling Price) Actual Units Sold Product A ($6.20 versus $6.00 8,000) Product B ($7.70 versus $8.00 33,000) Sales price variance

$1,600 Favorable 9,900 Unfavorable $8,300 Unfavorable

The sales volume variance equals (Actual Quantity versus Budgeted Quantity) Budgeted Selling Price Product A (8,000 versus 10,000 $6.00) Product B (33,000 versus 30,000 $8.00) Sales volume variance

$12,000 Unfavorable 24,000 Favorable $12,000 Favorable

The sales price variance indicates if the product is being sold at a discount or premium. Sales price variances may be due to uncontrollable market conditions or managerial decisions. The analysis of sales volume includes consideration of budgets, standards, sales plans, industry comparisons, and manufacturing costs. Note that high sales volume does not automatically mean high profits. There may be high costs associated with the products. An unfavorable sales volume variance may arise from poor marketing or price cuts by competing companies. If the unfavorable volume variance is coupled with a favorable price variance, the marketing manager may have lost sales by raising prices. The sales volume variance reflects the effect on the total budgeted contribution margin that is caused by changes in the total number of units sold. The variance can be caused by unpredictable product demand, lack of product demand, or poor sales forecasting. An unfavorable total sales variance may signal a problem with the marketing manager because he or she has control over sales, advertising, and often pricing. Another possible cause of the unfavorable sales situation may be a lack of quality

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control, substitution of poorer-quality components due to deficient purchasing, or deficient product design emanating from poor engineering. The sales variances (price and volume) are prepared only for the product sales report and the sales district report. The marketing manager is responsible for sales variances and must explain any deviations to upper management. An electronic spreadsheet can be used to compute sales variances.

Cost Variances When a product is made or a service is performed, three measures have to be determined: 1. Actual Cost Actual Price Actual Quantity, where Actual Quantity actual quantity per unit of work actual units of work produced 2. Standard Cost Standard Price Standard Quantity, where Standard Quantity standard quantity per unit of work actual units of work produced 3. Total (control) Variance Actual Cost Standard Cost Total (control) variance has these elements: ■

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Price (rate, cost) variance: (Standard Price versus Actual Price) Actual Quantity Quantity (usage, efficiency) variance: (Standard Quantity versus Actual Quantity) Standard Price Price as quantity variances are computed for both material and labor. A variance is unfavorable when actual cost is higher than standard cost.

Material Variances Quantity and delivery standards have to be established before a standard price per unit can be determined. Material price standards are set by the purchasing manager because he or she has knowledge of price date and market conditions. The manager should increase the initial standard price per unit to a standard weightedaverage price per unit to incorporate expected price increases for the period. The standard price should reflect the total cost of buying the material, which includes the basic price less discounts plus freight, receiving, and handling. The standard price must coincide with the specific quality material. In setting the material price standard, the price should be in accord with the firm’s inventory policies regarding the most economical order size and/or frequency of ordering. It is further assumed that buying, shipping, and warehousing will occur on favorable terms. Special bargain prices are ignored unless they are readily available. The material price standard should include normal or unavoidable spoilage allocations.

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The material price variance can be used to evaluate the activity of the Purchasing Department and to see the impact of raw material cost changes on profitability. A material price variance may be isolated at the time of purchase or usage. The material quantity variance is the responsibility of the production supervisor. Material quantity standards should include not only the raw materials but also purchased parts, cartons, and packing materials that are visible in, or can be directly related to, the product. Material quantity standards usually are determined from material specifications prepared by engineers, based on product design and production flow. The standard quantity should be based on the most economical size and quality of product. It should be increased to take into account normal waste, rejections, and spoilage. The standard should consider prior experience for the same or similar operation. Test runs may be made under controlled conditions. Material standards may be aided by analyzing previous experiences using descriptive statistics and/or test runs under controlled conditions. Physical standards for materials are based on determination of kind and quality specifications, quantity specifications, and assembly specifications. When many different types of raw materials are needed for a product, the types and standard quantities of each raw material is itemized on the standard bill of materials. Example 2 The standard cost of one unit of output (product or service) was $15: three pieces at $5 per piece. During the period, 8,000 units were made. Actual cost was $14 per unit; two pieces at $7 per piece. Total Material Variance Standard quantity times standard price (24,000 $5) Actual quantity times actual price (16,000 $7)

$120,000 112,000 $ 8,000 F

Material Price Variance (Standard price versus actual price) times actual quantity ($5 versus $7 16,000)

$ 32,000 U

Material Quantity Variance (Standard quantity versus actual quantity) times standard price (24,000 versus 16,000 $5)

$ 40,000 F

When the amount of material purchased is different from the amount issued to production, a price variance is determined at the time of purchase. When material is issued, a quantity (usage) variance is determined. In this case, the variances are determined in this way: Material Price Variance (Actual price versus standard price) times actual quantity bought Material Quantity Variance (Actual quantity issued versus standard quantity issued) times standard price

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Example 3 Material purchased was 20,000 pounds. Material issued to production was 15,000 pounds. Material budgeted per unit is 1 pound. Budgeted price is $2.50 per pound while actual price is $3.00 per pound. Production was 10,000 units. Material Price Variance (Actual price versus standard price) times quantity purchased ($3.00 versus $2.50) 20,000

$10,000 U

Material Quantity Variance (Actual quantity issued versus standard quantity) standard price (15,000 versus 10,000) $2.50

$12,500 U

Material price variances cannot be controlled when higher prices are due to inflation or shortage situations, or when rush orders are required by the customer, who will bear the ultimate cost increase. If the material price variance is favorable, one would expect higher quality material being acquired. Thus, a favorable usage variance should be forthcoming. If it is not, there is an inconsistency. A favorable material price variance may occur from other causes, such as when actual price is less than expected because of excess supply of the raw material. The controllable portion of a price variance should be segregated from the uncontrollable in management reports. Exhibit 8.1 presents a Daily Material Price Variance Report. Generally, the material quantity variance is the responsibility of the production manager. However, the purchasing manager will be responsible for inferior goods to economize on cost. The reason and responsible party for an unfavorable material variance follows. Reason

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Responsible party

Overstated price paid, failure to take discounts, improper specifications, insufficient quantities, use of a lower-grade material purchased to economize on price, uneconomical size of purchase orders, failure to obtain an adequate supply of a needed variety, purchase at an irregular time, or sudden and unexpected purchase required

Purchasing Manager

Poor mix of materials, poorly trained workers, improperly adjusted machines, substitution of nonstandard materials, poor production scheduling, poor product design or production technique, lack of proper tools or machines, carelessness in not returning excess materials to storeroom, or unexpected volume changes

Production Manager

Failure to detect defective goods

Receiving Manager

Inefficient labor, poor supervision, or waste on the production line

Foreman

Inaccurate standard price

Budgeting

Excessive transportation charges or too small a quantity purchased

Traffic management

Insufficient quantity bought because of a lack of funds

Financial

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Voucher No.

Item No.

Item Name

Vendor No.

Date___________________________________

Quantity Purchased

Per Unit Total

Standard Cost Per Unit Total

Actual Cost

Prepared by___________________________________

Details of Material Price Variance

Exhibit 8.1

Per Unit Total

Variance Percent from Standard

Explanation

Approved by___________________________________


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To correct an unfavorable material price variance, one can increase selling price, substitute cheaper materials, change a production method or specification, or engage in a cost-reduction program. An unfavorable price variance does not automatically mean the purchasing manager is not performing well. It may point to a need for new pricing, product, or buying decisions. For these purposes, price variances may be broken down by product, vendor class, or other appropriate distinction. When several types of raw materials are used, it might be better to break down the price variance by major category of material used (e.g., steel, paint). Tip: One should examine the variability in raw material costs. Look at price instability in trade publications. Emphasize vertical integration to reduce the price and supply risk of raw materials. To aid in identifying material usage variances, if additional material is required to complete the job, additional materials requisitions could be issued in a different color with a distinctive code number to show that the quantity of material is above standard. This approach brings attention to the excessive usage of materials while production is in process and allows for the early control of a developing problem. When material usage is recorded by flow meters, such as in chemical operations, usage variances can be identified on materials usage forms in a similar manner as excess labor hours identified on labor time tickets. Purchasing managers should have the option to acquire cheaper raw materials or to combine available resources so that overall corporate costs are minimized. For instance, slightly inferior raw materials (i.e., lower grade of metals) may intentionally be purchased at a bargain price. The material price variance may thus be quite favorable. However, such raw material component may cause above-average defective finished items and/or excessive productive labor hours, resulting in an unfavorable efficiency variance. The production manager may have permission to engage in this trade-off if it results in a significant net reduction in total manufacturing costs. A standard cost system should not be rigid in the sense that an unfavorable variance is regarded as always being bad. The production manager should look to see if overall objectives have been accomplished. Because many interdependencies exist, one should look at the entire picture rather than at just the fact that a given variance is unfavorable. When computing material price variances, it may be good to eliminate increasing costs due to inflation, which are not controllable by nonfinancial managers. Illustration of How Inflationary Cost Increases May Be Isolated from the Material Price Variance Assume these data for Charles Company for 20X1: Standard price of material per foot Actual price of material per foot Actual material used The inflation rate for the year is 16%

$3.00 3.80 10,000 ft.

The direct material price variance can be broken down into the inflation aspect and the controllable element.

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Price variance due to inflation (Standard price versus inflation adjusted price) actual quantity $3.00 versus $3.48 10,000 ft

$4,800

Controllable price variance (Inflation adjusted price versus actual price) actual quantity $3.48 versus $3.80 10,000 ft

$3,200

Proof—Material Price Variance (Standard price versus actual price) actual quantity $3.00 versus $3.80 10,000 ft

$8,000

It is important to have prompt reporting. Production managers should immediately be informed of variances so problems are identified and corrections made at the production level. Exhibit 8.2 presents a daily material usage report. Exhibit 8.3 presents a monthly material variance report.

Exhibit 8.2 Daily Material Usage Report Cost Center Material Type

Unit Date

Daily Date

Variance

Month

Variance Percent

Explanation

Variance

Year Variance Percent

Variance

Variance Percents

Exhibit 8.3 Monthly Material Variance Report Month Department

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Variance

Year to Date Percent

Variance

Percent

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Labor Variances Standard labor rates may be computed, based on the current rates adjusted for future changes in such variables as: ■ ■ ■ ■

Union contracts Changes in operating conditions Changes in the mix of skilled versus unskilled labor The average experience of workers

The wage system affects the standard cost rates. The basic rates are (1) day or hourly, (2) straight piece rate, and (3) multiple piece rates or bonus systems. Wage incentive systems can be tied to a standard cost system once standards have been formulated. Direct labor quantities may be obtained from engineering estimates. Line supervisors can corroborate the estimates by observing and timing employees. When salary rates are set by union contract, the labor rate variance usually will be minimal. For planning purposes, the rate standard should be the average rate expected to prevail during the planning period. Note: Labor rates for the same operation may vary due to seniority or union agreement. Labor time standards should include only the elements controllable by the worker or work center. If the major purpose of a cost system is control, there should be a tight labor time standard. If costing or pricing is the major purpose of the cost system, looser labor standards are needed. Labor efficiency standards typically are estimated by engineers on the basis of an analysis of the production operation. The standard time may include allowances for normal breaks, personal needs, and machine downtime. Labor variances are determined in a manner similar to that in which material variances are determined. Labor variances are isolated when labor is used for production.

Example 4 The standard cost of labor is four hours times $9 per hour, or $36 per unit. During the period, 7,000 units were produced. The actual cost is six hours times $8 per hour, or $48 per unit. Total Labor Variance Standard quantity times standard price (28,000 $9) Actual quantity times actual price (42,000 $8)

$ 252,000 336,000 $ 84,000 U

Labor Price Variance (Standard price versus actual price) times actual quantity ($9 versus $8 42,000)

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$ 42,000 F

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Labor Quantity Variance (Standard quantity versus actual quantity) standard price (28,000 versus 42,000 $9)

$126,000 U

Possible causes of unfavorable labor variances are: For a labor price (rate) variance: ■ ■ ■

Increase in wages Poor scheduling of production, resulting in overtime work Use of workers commanding higher hourly rates than expected For a labor efficiency variance:

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Poor supervision Use of unskilled workers paid lower rates or the wrong mixture of labor for a given job Use of poor-quality machinery Improperly trained workers Poor quality of materials, requiring more labor time in processing Machine breakdowns Employee unrest Production delays due to power failure Possible reasons for a labor price variance and the person responsible follow. Reason

Responsible Party

Use of overpaid or excessive number of workers

Production manager or union contract

Poor job descriptions or excessive wages

Personnel

Overtime and poor scheduling of production

Production Planning

In the case of a shortage of skilled workers, it may be impossible to avoid an unfavorable labor price variance. Price variances due to external factors are beyond the nonfinancial manager ’s control (e.g., a new minimum wage established by the government). The cause and responsible party for an unfavorable labor efficiency variance follow.

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Cause

Responsible Entity

Poor-quality workers or poor training

Personnel or Training

Inadequate supervision, inefficient flow of materials, wrong mixture of labor for a given job, inferior tools, or idle time from production delays

Foreman

Employee unrest

Personnel or Foreman

Improper functioning of equipment

Maintenance

Insufficient material supply or poor quality

Purchasing

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To control against an unfavorable labor efficiency variance due to inadequate materials or sales orders, a daily direct labor report should be prepared. An unfavorable labor efficiency variance may indicate that better machinery is needed, plant layout should be revised, improved operating methods are needed, and better employee training and development are required. If a permanent change occurs in the amount of labor required or the labor wage rate for the various types of employee help, the production manager may wish to switch to more capital assets than labor. Variances interrelate. A favorable labor efficiency variance coupled with an unfavorable labor rate variance may mean that higher skilled labor was employed than was necessary. However, the production manager would be justified in doing this if a rush order arose in which the selling price was going to be upwardly adjusted. Exhibit 8.4 presents a daily labor mix report. Exhibit 8.5 presents a labor performance report. Looking at this report aids in evaluating labor effectiveness and coming up with a revision in labor policies. A graph of weekly labor efficiency is presented in Exhibit 8.6.

Exhibit 8.4 Daily Labor Mix Report Department Skill level

Actual Hours in Standard Proportions

Actual Hours

Output Variance

I II III

Exhibit 8.5 Labor Performance Report Department Day Machine Operator

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Achieved in Percent

Date Explanation

Month to Date in Percent

Year to Date in Percent

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Exhibit 8.6 Labor Efficiency by Week Year

Percent

Department 120 115 110 105 100 95 90 85 80 0

5

10

15

20

25

30

35

40

45

50

Week

Overhead Variances Management is concerned with the trade-off between fixed and variable costs. As the output level increases, the capital-intensive business will be more efficient. The cost associated with a wrong decision is the variance between the total costs of operating the given plant and the total costs of operating the most efficient one based on the actual output level. Overhead variances may be determined by department and by cost center. Fixed and variable overhead variances should be analyzed independently. In many firms, variances are expressed in both dollars and physical measures. Variable Overhead Variances The two variances associated with variable overhead are price (spending) and efficiency. Variable Overhead Price (Spending) Variance Actual variable overhead versus budget adjusted to actual hours (actual hours standard variable overhead rate) Variable Overhead Efficiency Variance Budget adjusted to actual hours versus budget adjusted to standard hours (standard hours standard variable overhead rate)

Variable overhead variance information is helpful in arriving at the output level and output mix decisions. The production manager is usually responsible for any variable overhead variance that might occur. This variance also assists in appraising decisions regarding variable inputs.

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Example 5 The standard hours are three hours per unit. The standard variable overhead rate is $12 per hour. Actual variable overhead is $13,000. There are 2,500 actual hours. Production is 1,000 units. The variable overhead variances are: Variable Overhead Price Variance Actual variable overhead Budget adjusted to actual hours (2,500 $4) Price Variance

$13,000 10,000 $ 3,000 U

Variable Overhead Efficiency Variance Budget adjusted to actual hours Budget adjusted to standard hours (3,000 $4) Efficiency Variance

$10,000 12,000 $ 2,000 F

Fixed Overhead Variances Fixed overhead may be analyzed in terms of the budget (flexible budget, spending) variance and volume (production volume) variances. The volume variance may be further broken down into the efficiency and pure volume variances. Fixed Overhead Budget Variance Actual fixed overhead versus budgeted fixed overhead (denominator or budget hours standard fixed overhead rate)

Note: Budgeted fixed overhead also may be referred to as lump-sum amount. Fixed Overhead Volume Variance Budgeted fixed overhead versus standard overhead (standard hours standard fixed overhead rate)

The breakdown of the volume variance follows. Fixed Overhead Efficiency Variance (Actual hours versus standard hours) standard fixed overhead rate Fixed Overhead Pure Volume Variance (Actual hours versus budgeted hours) standard fixed overhead rate

Fixed overhead variance data provide information about decision-making astuteness when buying some combination of fixed plant size variable production inputs. However, variances for fixed overhead are of questionable usefulness for control purposes, since these variances are usually beyond the control of the production manager. The volume variance is a measure of the cost of deviating from denominator (budgeted) volume used to set the fixed overhead rate. When actual volume is less than budgeted volume, the volume variance will be unfavorable. In the opposite

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case, the volume variance is favorable because it is considered as a benefit of better-than-anticipated utilization of facilities. Example 6 Standard hours are two hours per unit. Standard fixed overhead rate is $20 per hour. Actual hours per unit are two. Total production is 9,500 units. Actual hours are 20,200. Actual fixed overhead is $420,000. The denominator activity is 10,000 units. The fixed overhead variances are: Fixed Overhead Budget Variance Actual fixed overhead Budgeted fixed overhead (10,000 2 = 20,000 $20) Budget Variance

$420,000 400,000 $ 20,000 U

Volume Variance Budgeted fixed overhead Standard fixed overhead (9,500 2 = 19,000 $20) Volume Variance

$400,000 380,000 $ 20,000 U

The production volume variance of $20,000 is now broken down into the efficiency and pure volume variances. Fixed Overhead Efficiency Variance (Actual hours versus standard hours) standard fixed overhead rate (20,200 versus 19,000) $20

$ 24,000 U

Fixed Overhead Pure Volume Variance (Actual hours versus budget hours) standard fixed overhead rate (20,200 versus 20,000) $20

$ 4,000 F

Variances for Total Overhead One way, two-way, and three-way analysis may be used for total overhead. One-Way Method The total (control, net) variance is: Total Overhead Variance Actual overhead Standard overhead (standard hours standard overhead rate) Two-Way Method Under the two-variance method, the overhead variance comprises the controllable (budget, flexible budget, spending) and volume (capacity, idle capacity, activity, denominator) variances.

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Controllable Variance Actual overhead Budget adjusted to standard hours Fixed overhead (denominator hours standard fixed overhead rate) Variable overhead (standard hours standard variable overhead rate) Volume (Production) Variance Standard overhead Budget adjusted to standard hours

The controllable (budget) variance may indicate changes in the amount charged for overhead services or in the correlation between overhead items and the variable used to measure output. If such changes are permanent, output levels may have to be revised. Managers use the overhead budget variance as a basis for determining the extent to which the cost centers were within their budgeted cost levels. Such variances are useful in formulating decisions regarding cost center operations. The controllable variance is the responsibility of the foreman, because he or she influences actual overhead incurred. An unfavorable variance may be due to price increases, a lack of control over costs, and waste. The volume variance is the responsibility of production managers, since they are involved with plant utilization. Note: A consistently unfavorable volume variance may be due to having purchased the incorrect size plant. An unfavorable volume variance may arise from controllable factors such as poor scheduling, lack of orders, shortages or defectiveness in raw materials, inadequate tooling, lack of employees, machine breakdowns, long operating times, and incompetent workers. Uncontrollable factors for the overhead volume variance are decrease in customer demand, excess plant capacity, and calendar fluctuations (e.g., differences in number of working days in a month). Overhead capacity variances can bring to a production manager ’s attention the existence of slack resources. Idle capacity may imply long run operating planning deficiencies. The volume of activity often is determined outside the factory, based on customer orders. If this is the case, volume variances may not be controllable by the department head or even by the plant manager. They still should be reported to plant managers to help in explaining the total overhead variance to higher management. Responsibility for the factory overhead volume variance rests with those responsible for generating volume. In some cases, marketing managers, rather than manufacturing managers, bear this responsibility. Possible Reasons for a Recurring Unfavorable Overhead Volume Variance ■ ■

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Buying the wrong size plant Improper scheduling

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Insufficient orders Shortages in material Machinery failure Long operating time Inadequately trained workers

The existence of idle capacity may indicate long-term operating planning problems. A deficiency of controllable overhead variance analysis is the failure to segregate the responsibility for increased costs due to inflation from those due to inefficient spending. This deficiency can be corrected through a revised method of overhead analysis, taking into account inflation. Note: A favorable variance may be causing an unfavorable one. For example, lower maintenance expenditures for equipment may lower the overhead budget variance, but lead to machinery breakdowns and cause an unfavorable volume variance. Three-Way Method The three-variance method involves further analysis of the two-variance method. The three-way approach consists of the spending, efficiency, and volume variances. Note: The volume variance is identical under the three-way and two-way approaches. The controllable variance under the two-way method is broken down into the spending and efficiency variances under the three-way method. Spending Variance Actual overhead Budget adjusted to actual hours Fixed overhead (denominator hours standard fixed overhead rate) Variable overhead (Actual hours standard variable overhead rate) Efficiency Variance Budget adjusted to actual hours Budget adjusted to standard hours Volume (Production) Variance Budget adjusted to standard hours Standard overhead

The efficiency variance is the production manager ’s responsibility and arises from inefficiencies or efficiencies in the production process. The variance is unfavorable when actual hours exceed standard hours charged to production. Inefficiencies may arise from such factors as unskilled labor, modification of operations, deficient machinery, and inferior quality materials. Spending and efficiency variances are the responsibility of the department supervisor. The volume variance is attributable to executive management because the decision as to the degree of plant utilization rests with them. Idle capacity may be due to the lack of a proper balance between production facilities and sales.

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It may also arise from a favorable selling price that recovers fixed overhead at an exceptionally low production level. Example 7 The standards for total overhead are: Variable overhead Fixed overhead

2 hrs. @ $ 6 = $12 per unit 2 hrs. @ $20 = $40 per unit

The actual figures are: Production 9,500 units Denominator activity 10,000 units Variable overhead $115,000 Fixed overhead $420,000 Actual hours 20,200 Part 1: One-Way Analysis Control Variance Actual overhead ($115,000 = $420,000) Standard overhead (9,500 2 = 19,000 $26) Control variance

$535,000 494,000 $ 41,000 U

Part 2: Two-Way Analysis Controllable Variance Actual overhead Budget adjusted to standard hours Fixed overhead (10,000 2 = 20,000 $20) Variable overhead (19,000 $6)

$535,000 $400,000 114,000

Controllable Variance

514,000 $ 21,000 U

Volume (Production) Variance Budget adjusted to standard hours Standard overhead Volume Variance

$514,000 494,000 $ 20,000 U OR

Budgeted hours Standard hours Difference in hours Fixed overhead rate Volume Variance

20,000 19,000 1,000 $20 $ 20,000 U

Part 3: Three-Way Analysis Spending Variance Actual overhead Budget adjusted to actual hours Fixed overhead (10,000 2 = 20,000 $20) Variable overhead (20,200 $6) Spending Variance

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$535,000 $400,000 121,200 $521,200 $ 13,800 U

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Efficiency Variance Budget adjusted to actual hours Budget adjusted to standard hours Efficiency Variance

$521,200 514,000 $ 7,200 U OR

Actual hours Standard hours Difference in hours Standard variable overhead rate Efficiency Variance

20,200 19,000 1,200 $6 $ 7,200 U

Volume Variance Budget adjusted to standard hours Standard overhead Volume Variance

$514,000 494,000 $ 20,000 U

Example 8 presents comprehensive illustration showing all the variances for material, labor, and overhead. Example 8 These standards are given: Per Unit Direct Material Direct Labor Variable overhead Fixed overhead

5 lbs. @ $ 4 per lb. 3 hrs. @ $12 per hr. 3 hrs. @ $ 7 per hr. 3 hrs. @ $20 per hr.

$ 20 36 21 60 $137

Actual data follow: Production 9,800 units Denominator (budget) activity 11,000 units Purchases 50,000 lbs. @ $150,000 Direct material used 44,000 lbs. Direct labor 22,000 hrs. @ $220,000 Variable overhead $125,000 Fixed overhead $450,000 Part 1: Material Material Price Variance (Actual price versus standard price) actual quantity bought ($3 versus $4) 50,000

$ 50,000 F

Material Quantity Variance (Actual quantity issued versus standard quantity) standard price (44,000 versus 49,000) $4

$ 20,000 F

Part 2: Labor Control Variance Standard quantity standard price (29,400 $12 Actual quantity actual price (22,000 $10) Control Variance

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$352,800 220,000 $132,800 F

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Labor Price Variance (Actual price versus standard price) actual quantity ($10 versus $12) 22,000

$ 44,000 F

Labor Quantity Variance (Actual quantity versus standard quantity) standard price (22,000 versus 29,400*) $12 *9,800 3 = 29,400

$ 88,800 F

Part 3: Variable Overhead Variable Overhead Price Variance Actual variable overhead Budget adjusted to actual hours (22,000 $7) Price Variance

$125,000 154,000 $ 29,000 F

Variable Overhead Efficiency Variance Budget adjusted to actual hours Budget adjusted to standard hours (9,800 3 = 29,400 $7) Efficiency Variance

$154,000 205,800 $ 51,800 F

Part 4: Fixed Overhead Fixed Overhead Budget Variance Actual fixed overhead Budgeted fixed overhead (11,000 3 = 33,000 $20) Budget Variance

$450,000 660,000 $210,000 F

Fixed Overhead Volume Variance Budgeted fixed overhead Standard overhead (9,800 3 = 29,400 $20) Volume Variance

$660,000 588,000 $ 72,000 U

The fixed overhead volume variance is broken down into the fixed overhead efficiency variance and fixed overhead pure volume variance. Fixed Overhead Efficiency Variance (Actual hours versus standard hours) standard fixed overhead rate (22,000 versus 29,400) $20

$148,000 F

Fixed Overhead Pure Volume Variance (Actual hours versus budgeted hours) standard fixed overhead rate (22,000 versus 33,000) $20

$220,000 U

Part 5: One-Way Analysis Total Overhead Variance Actual overhead Standard overhead (29,400 $27) Total Overhead Variance

$575,000 793,800 $218,800 F

Part 6: Two-Way Analysis Controllable Variance Actual overhead

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$575,000

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Budget adjusted to standard hours Fixed overhead (11,000 3 = 33,000 $20) Variable overhead (9,800 3 = 29,400 $7) Controllable Variance

$660,000 205,800

865,800 $290,800 F


$865,800 793,800 $ 72,000 U

Part 7: Three-Way Analysis Spending Variance Actual overhead Budget adjusted to actual hours Fixed overhead (11,000 3 = 33,000 $20) Variable overhead (22,000 $7) Spending Variance

$575,000 $660,000 154,000

814,000 $239,000 F

Efficiency Variance Budget adjusted to actual hours Budget adjusted to standard hours Efficiency Variance

$814,000 865,800 $ 51,800 F


$865,800 793,800 $ 72,000 U

Interrelationship of Variances With regard to variance analysis for all production costs (direct material, direct labor, and overhead), it is important to note that each variance does not represent a separate and distinct problem to be handled in isolation. All variances in one way or another are interdependent. For example, the labor rate variance may be favorable because lower-paid workers are being used. This could lead to an (1) unfavorable material usage variance because of a higher incidence of waste, (2) unfavorable labor efficiency variance because it takes longer hours to make the equivalent number of products, (3) unfavorable overhead efficiency variance because the substandard work causes more hours to be spent for a specified output, and (4) unfavorable overhead volume variance arising from abnormally high machine breakdowns because of less skilled operators. A trade-off between variances may be a manager ’s objective. For example, a material price variance may be favorable because of a bargain purchase opportunity or because of a combination of available resources designed to save overall costs. However, the raw material acquired may be somewhat inferior in quality to that which is usually purchased. In processing, use of this material may lead to greater waste or more labor hours in producing a finished item that will satisfy product quality guidelines. The goal here may be to minimize total production

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costs through the trade-off of a favorable price variance and an unfavorable quantity variance. The net effect of the variances, in this case, is what counts.

Mix and Yield Variances for Material and Labor Mix refers to the relative proportion of various ingredients of input factors such as materials and labor. Yield is a measure of productivity. Material and Labor Mix Variances The material mix variance indicates the impact on material costs of the deviation from the standard mix. The labor mix variance measures the impact of changes in the labor mix on labor costs. Formulas Material ⎛⎜ Actual Units Actual Units⎞⎟⎟ Standard ⎜⎜ ⎟⎟ ⎜ ⎟⎟ Unit Mix ⎜Used at Used at ⎟⎟ ⎜⎜ Variance ⎜⎝Standard Mix Actual Mix ⎟⎠ Price ⎛⎜Actual Hrs. Labor Actual Hrs.⎞⎟ Standard ⎟⎟ ⎜ ⎟⎟ Hourly Mix = ⎜⎜⎜ Used at Used at ⎟⎟ ⎜ Variance ⎜⎜⎝Standard Mix Actual Mix⎟⎟⎠ Price

Mix and Yield Variances The material quantity variance is divided into a material mix variance and a material yield variance. The material mix variance measures the impact of the deviation from the standard mix on material costs, while the material yield variance reflects the impact on material costs of the deviation from the standard input material allowed for actual production. We compute the material mix variance by holding the total input units constant at their actual amount. We compute the material yield variance by holding the mix constant at the standard amount. The computations for labor mix and yield variances are the same as those for materials. If there is no mix, the yield variance is the same as the quantity (or usage) variance. Formulas Material ⎛⎜Actual Units Actual Units ⎞⎟ Standard ⎟⎟ ⎜ ⎟⎟ Unit Yield = ⎜⎜⎜ Used at − Output at ⎟⎟ ⎜ Variance ⎜⎜⎝Standard Mix Standard Mix⎟⎟⎠ Price

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Labor Yield Actual Hrs. Used at Actual Output Hrs. at Standard Hourly Standard Mix Price Standard Mix Variance

Probable Causes of Unfavorable Mix Variances ■ ■ ■ ■

Capacity restraints force substitution. Poor production scheduling Lack of certain types of labor Certain materials are in short supply.

Probable Causes of Unfavorable Yield Variances ■ ■ ■ ■

The use of low-quality materials and/or labor The existence of faulty equipment The use of improper production methods An improper or costly mix of materials and/or labor

Example 9 (Mix Variances) J Company produces a compound composed of Materials Alpha and Beta, which is marketed in 20-pound bags. Material Alpha can be substituted for Material Beta. Standard cost and mix data have been determined as follows: Unit Price Material Alpha Material Beta

Standard Unit

$3 4

Standard Mix Proportions

5 lbs. 15 20 lbs.

25% 75 100%

Processing each 20 pounds of material requires 10 hours of labor. The company employs two types of labor, skilled and unskilled, working on two processes, assembly and finishing. The following standard labor cost has been set for a 20-pound-bag. Standard Hrs. Unskilled Skilled

4 hrs. 6 10

Standard Wage Rate

Total

$2 3 $2.60

Standard Mix Proportions

$8 18 $26

40% 60 100%

At standard cost, labor averages $2.60 per unit. During the month of December, 100 20-pound bags were produced with these labor costs:

Unskilled Skilled

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Actual Hrs.

Actual Rate

Actual Wages

380 hrs. 600 980

$2.50 3.25

$ 950 1,950 $2,900

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Material records show: Beginning Inventory Material Alpha Material Beta

100 lbs. 225

Purchase 800 @ $3.10 1,350 @ $3.90

Ending Inventory 200 lbs. 175

We now want to determine these following variances from standard costs: ■ ■ ■ ■ ■ ■

Material purchase price Material mix Material quantity Labor rate Labor mix Labor efficiency We will show how to compute these variances in a tabular form.

(a) Material Purchase Price Variance Material Price per Unit

Material Alpha Material Beta

Standard

Actual

Difference

$3 4

$3.10 3.90

$.10 U .10 F

Actual Quantity Purchased 800 lbs. 1,350

Variance ($) $ 80 U 135 F $ 55 F

(b) Material Mix Variance Units that Should Have Been Used at Standard Mix* Material Alpha Material Beta

525 lbs. 1,575 2,100

Actual Units at Actual Mix† 700 lbs. 1,400 2,100

Difference

Standard Unit Price

175 U 175 F

$3 4

Variance ($) $525 U 700 F $175 F

The material mix variance measures the impact on material costs of the deviation from the standard mix. Therefore, it is computed holding the total quantity used constant at its actual amount and allowing the material mix to vary between actual and standard. As shown, due to a favorable change in mix, we ended up with a favorable material mix variance of $175. *This is the standard mix proportions of 25% and 75% applied to the actual material units used of 2,100 lbs. † Actual units used = Beginning inventory + purchases – Ending inventory.

Therefore, Material Alpha: 700 lbs. 100 800 200 Material Beta: 1,400 lbs. 225 1,350 175

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(c) Material Quantity Variance

Material Alpha Meterial Beta

Units that Should Have Been used at Standard Mix

Standard Units at Standard Mix

525 lbs. 1,575 2,100

500 lbs. 1,500 2,000

Diff.

Standard Unit Price

25 U 75 U

$3 4

Variance ($) $75 U 300 U $375 U

The total material variance is the sum of the three variances: Purchase price variance Mix variance Quantity variance

$ 55 F 175 F 375 U $145 U

The increase of $145 in material costs was due solely to an unfavorable quantity variance of 100 pounds of material Alpha and Beta. The unfavorable quantity variance, however, was compensated largely by favorable mix and price variances. J Company must look for ways to cut down waste and spoilage. The labor cost increase of $300 ($2,900 $2,600) is attributable to three causes: 1. An increase of $.50 per hour in the rate paid to skilled labor and $.25 per hour in the rate paid to unskilled labor 2. An unfavorable mix of skilled and unskilled labor 3. A favorable labor efficiency variance of 20 hours Three labor variances are computed next. (d) Labor Rate Variance Labor Rate per Hr.

Unskilled Skilled

Standard

Actual

Diff.

Actual Hrs. Used

$2 3

$2.50 3.25

$.50 U .25 U

380 hrs. 600

Variance ($) $190 U 150 U $340 U

(e) Labor Mix Variance

Unskilled Skilled

Actual Hrs. at Standard Mix*

Actual Hrs. at Actual Mix

392 hrs. 588 980

380 hrs. 600 980

Diff.

Standard Rate

12 F 12 U

$2 3

Variance ($) $24 F 36 U $12 U

*This is the standard proportions of 40% and 60% applied to the action total labor hrs. used of 980.

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(f) Labor Efficiency Variance

Actual Hrs. at Standard Mix

Standard Hrs. at Standard Mix

392 hrs. 588 980

400 hrs. 600 1,000

Unskilled Skilled

Diff.

Standard Rate

8F 12 F

$2 3

Variance ($) $16 F 36 F $52 F

The total labor variance is the sum of these three variances: Rate variance Mix variance Efficiency variance

$340 U 12 U 52 F $300 U

which is proved to be:

Unskilled Skilled

Actual Hrs. Used

Actual Rate

380 hrs. 600

$2.50 3.25

Total Actual Cost

Standard Hrs. Allowed

Standard Rate

$ 950 1,950 $2,900

400 600

$2 3

Total Standard Cost

Variance ($)

$ 800 1,800 $2,600

$150 U 150 U $300 U

The unfavorable labor variance, as evidenced by the cost increase of $300, may be due to: ■

■

Overtime necessary because of poor production scheduling resulting in a higher average labor cost per hour, and or Unnecessary use of more expensive skilled labor J Company should put more effort into better production scheduling.

Example 10 (Yield Variances) The Giffen Manufacturing Company uses a standard cost system for its production of a chemical product. This chemical is produced by mixing three major raw materials, A, B, and C. The company has these standards: 36 lbs. of Material A 48 lbs. of Material B 36 lbs. of Material C 120 lbs. of Standard mix

@ @ @ @

$1.00 2.00 1.75 $1.625

$ 36.00 96.00 63.00 $195.00

The company should produce 100 pounds of finished product at a standard cost of $1.625 per pound ($195.00/120 lbs.)

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Converting 120 pounds of materials into 100 pounds of finished chemical requires 400 DLH at $3.50 per DLH, or $14.00 per pound. During the month of December, the company produced 4,250 pounds of output with direct labor of 15,250 hrs. @ $3.50. Materials Purchased During the Month

Materials Used During the Month

1,200 @ $1.10 1,800 @ 1.95 1,500 @ 1.80

1,160 lbs. 1,820 1,480

Material A Material B Material C

The material price variance is isolated at the time of purchase. We want to compute the material purchase price, quantity, mix, and yield variances. We will show the computations of variances in a tabular form. (a) Material Variance Material Purchase Price Variance

Standard

Actual

Diff.

Actual Quantity Purchased

$1.00 2.00 1.75

$1.10 1.95 1.80

$.10 U .05 F .05 U

1,200 lbs. 1,800 1,500

Material Price per Unit


Variance ($) $120 U 90 F 75 U $105 U

The material quantity variance computed next results from changes in the mix of materials as well as from changes in the total quantity of materials. The standard input allowed for actual production consists of 1,275 pounds of Material A, 1,700 pounds of Material B and 1,275 pounds of Material C, a total of 4,250 pounds. The actual input consisted of 1,160 pounds of Material A, 1,820 pounds of Material B and 1,480 pounds of Material C, a total of 4,460 pounds. To separate these two changes, the material quantity variance is subdivided into a material mix variance and a material yield variance. Material Quantity Variance


Actual Units Used at Actual Mix

“Should Have Been” Inputs Based on Actual Output

1,160 lbs. 1,820 1,480 4,460

1,275 lbs. 1,700 1,275 4,250

Diff.

Standard Unit Price

115 F 120 U 205 U

$1.00 2.00 1.75

Variance ($) $ 115 F 240 U 358.75 U $ 483.75 U

The computation of the material mix variance and the material yield variance for the Giffen Manufacturing Company is given next.

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Material Mix Variance


“Should Have Been” Individual Inputs Based on Total Actual Throughout*

Actual Units Used at Actual Mix

1,338 lbs. 1,784 1,338 4,460

1,160 lbs. 1,820 1,480 4,460

Diff.

Standard Unit Price

178 F 36 U 142 U

$1.00 2.00 1.75

Diff.

Standard Unit Price

63 U 84 U 63 U

$1.00 2.00 1.75

Variance ($) $ 178 F 72 U 248.5 U $412.5 U

Material Mix Variance


Expected Input Units at Standard Mix

“Should Have Been” Inputs Based on Actual Output*

1,338 lbs. 1,784 1,338 4,460

1,275 lbs. 1,700 1,275 4,250

Variance ($) $ 63 U 168 U 110.25 U $341.25 U†

*

This is the standard mix proportion of 30%, 40%, and 30% applied to the actual throughput of 4,460 pounds or output of 4,250 pounds. † The material yield variance of $341.25 U can be computed alternatively in this way:

Actual input quantity at standard prices Material A 1,338 lbs. @ $1.00 $1,338 Material B 1,784 lbs. @ 2.00 3,568 Material C 1,338 lbs. @ 1.75 2,341.5 $7,274.50 Actual output quantity at standard price 4,250 lbs.

@ 1.625

$6,906.25

Hence, $7,247.5 $6.906.25 = $341.25 U

The material mix and material yield variances are unfavorable, indicating that a shift was made to a more expensive (at standard) input mix and that an excessive quantity of material was used. Poor production scheduling requiring an unnecessarily excessive use of input materials and an undesirable mix of Materials A, B, and C was responsible for this result. To remedy the situation, the company must ensure that four steps are taken: 1. The material mix is adhered to in terms of the least cost combination without affecting product quality. 2. The proper production methods are being implemented.

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3. Inefficiencies, waste, and spoilage are within the standard allowance. 4. Quality materials, consistent with established standards, are being used. Employees seldom complete their operations according to standard times. Two factors should be brought out in computing their variances if the analysis and computation will be used to fix responsibility: 1. The change in labor cost resulting from the efficiency of the workers, measured by a labor efficiency variance. (In finding the change, allowed hours are determined through the material input.) 2. The change in labor cost due to a difference in the yield, measured by a labor yield variance. (In computing the change, actual output is converted to allowed input hours.) For the Giffen Manufacturing Company, more efficient workers resulted in a savings of 383.33 hours (15,250 hrs. 14,866.67 hrs.). Priced at the standard rate per hour, this produced an unfavorable labor efficiency variance of $1,341.66 as shown next: Labor Efficiency Variance Actual hrs. at standard rate Actual hrs. at expected output (4,460 hrs. 400/120 = 14,866.67 hrs @ $3.5)

$53,375 52,033.34 $ 1,341.66 U

With a standard yield of 83¹/³% (= 100/120), 4,250 pounds of finished material should have required 17,000 hours of direct labor (4,250 lbs. 400 DLH/100). Comparing the hours allowed for the actual input, 14,866.67 hours with the hours allowed for actual output, 17,000 hours, we find a favorable labor yield variance of $7,466.66, as shown next. Labor Yield Variance Actual hrs. at expected output Actual output (4,250 lbs. 400/100 17,000 hrs. @ $3.5 or 4,250 lbs. @ $14.00)

$52,033.34 59,500 $ 7,466.66 F

The labor efficiency variance can be combined with the yield variance to give us the traditional labor efficiency variance, which turns out to be favorable. Labor efficiency variance Labor yield variance

$1,341.66 U 7,466.66 F $ 6,125 F

This division is necessary when there is a difference between the actual yield and standard yield, if responsibility is to be fixed. The production manager cannot

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be credited with a favorable efficiency variance of $6,125. Note, however, that a favorable yield variance, which is a factor most likely outside the control of the producing department, more than offsets the unfavorable labor efficiency variance of $1,341.66 for which the producing department should have been responsible.

Profit Variance Analysis Gross profit analysis is determining the causes for the change in gross profit. Any variances that have an impact on gross profit are reported so corrective steps may be taken. Causes of Profit Variance ■ ■ ■

Changes in unit sales price and cost Changes in the volume of products sold Changes in sales mix

Analysis of the changes furnishes data needed to bring actual operations in line with budgeted expectations. Comparisons should be made between budgeted and actual operations for the current year or between actual operations for the previous year and those for the current year. Changes in gross profit may be looked at in terms of the entire company or by product line. In an effort to improve profitability, the change in character of sales or mix of sales is just as important as the increase in total volume. For example, if the total volume in the budget is constant, but a larger proportion of high-margin products is sold than was budgeted, then higher profits will result. For instance, in the furniture business, there is an increasing trend toward more expensive and durable pieces carrying a higher margin per unit, although volume may not be all that great. Computations and analysis of sales mix variances are a very important part of profit analysis. It provides an additional insight into (a) what caused the increase or decrease in profit over the previous year and (b) why the actual profit differed from the original expectation. Gross profit (or contribution margin) is usually the joint responsibility of sales managers and production managers. The sales manager is responsible for the sales revenue component, and the production manager is accountable for the cost-ofgoods-sold component. However, it is the task of top management to ensure that the target profit is met. The sales manager must hold fast to prices, volume, and mix. The production manager must control the costs of materials, labor and factory overhead, and quantities. The purchasing manager must purchase materials at budgeted prices. The personnel manager must employ the right people at the right wage rates. The internal audit manager must ensure that the budgetary figures for sales and costs are being adhered to by all departments that are, directly or indirectly, involved in contributing to making profit. The computation of the production mix variance is very similar to that of the sales mix variance. While the sales mix variance is part of profit analysis,

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the production mix variance for materials and labor is an important part of cost variance analysis. We must realize, however, that the analysis of standard cost variances should be understood as part of what is broadly known as profit analysis. In industries where each cost element is substituted for each other and production is at or near full capacity, how we combine different types of materials and different classes of labor will affect the extent to which the costs are controlled and gross profit maximized. The production volume variance must be further analyzed to separate the effect on costs of a change in mix of the production inputs such as materials and labor. The yield variances for materials, labor, and overhead are useful in controlling material consumption. In some cases, the newly found mix is accompanied by either a favorable or an unfavorable yield of the finished product. Usually the favorable mix variance may be offset by an unfavorable yield variance, or vice versa. It is the responsibility of the laboratory or the engineering manager to make sure that no apparent advantage created by one type of variance is canceled out by another. Taken as a whole, the analysis of profit involves careful evaluation of sales variances and cost variances. In particular, the effect of changes in mix, volume, and yield on profits must be separated and analyzed. The analysis of these variances provides managers with added dimensions of responsibility since it provides additional insight into what caused the increase or decrease in profits or why the actual profit deviated from the target profit. Analyzing the change in gross profit via an effective responsibility system based on the control of costs and sales variances is a step toward maximization of profits. We now discuss the computation of the profit variances. Profit Variance Analysis for a Single Product: (a) Sales price variance = (Actual price Budget or standard price) Actual sales (b) Costs price variance = (Actual cost Budget or standard cost) Actual sales (c) Sales volume variance = (Actual sales Budget or standard sales) Budget or standard price (d) Cost volume variance = (Actual sales Budget or standard sales) Budget or standard cost per unit Profit Variance Analysis for Multiple Products: The total volume variance in a multiple product situation is comprised of (a) sales mix variance and (b) sales quantity variance. (a) Sales mix variance =

sales at budget Budget or standard sales Budget orstandard at budget or standard mix CM(or GM) per unit orActual standard mix

CM = contribution margin and GM = gross margin.

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(b) Sales quantity variance Budgeted or standard CM (or GM) per unit

Actual sales at budgeted Actual sales at budgeted or standard mix or standard mix (c) Total volume variance Sales mix variance + sales quantity variance

or Actual sale at budgeted or actual mix

Budgeted or standard sales Budgeted or standard at budgeted or standard mix CM (or GM) per unit

The sales price variance and the cost price variance are calculated the same way as for a single product. Frequently, a contribution margin approach is superior to the gross profit approach. That is because gross profit as a deduction for fixed costs may be beyond the control of the nonfinancial manager. A simple example follows. Budget

Sales Price Units Variable Manufacturing Costs Fixed Manufacturing Costs Manufacturing Contribution Margin per Unit Gross Profit per Unit

Actual

Variance

Unit A

Unit B

Unit A

Unit B

Unit A

Unit B

$10 10

$5 8

$11 10

$6 8

$1F -0-

$1U -0-

$ 4

$3

$ 6

$4

$2U

$1U

$ 3

$1

$ 4

$2

$1U

$1U

$ 6

$2

$ 5

$2

$1 U

$-0-

$ 3

$1

$ 1

$0

$2 U

$1 U

Using these data, an unfavorable manufacturing contribution margin variance of $10 ($1 10 units) for Unit A and $0 ($0 8 units) for Unit B is more meaningful than the $20 ($2 10 units) and $8 ($1 8 units) unfavorable gross profit variance, if local managers had no control over fixed costs.

Example 11 (Profit Variance Analysis) The Lake Tahoe Ski Store sells two ski models, Model X and Model Y. For the years 20X1 and 20X2, the store realized a gross profit of $246,640 and only $211,650, respectively. The owner of the store was astounded, since the total sales volume in dollars and in units was higher for 20X1 than for 20X2, yet the gross profit actually declined. Given below are the store’s unaudited operating results for 20X1 and 20X2. No fixed costs were included in the cost of goods sold per unit.

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Budgeting Basics and Beyond Model X

Year 1 2

Model Y

Selling Price

Cost of Goods Sold per Unit

Sales (in Units)

Sales Revenue

Selling Price

$150 160

$110 125

2,800 2,650

$420,000 424,000

$172 176

Cost of Goods Sold Sales per Unit (in Units) $121 135

2,640 2,900

Sales Revenue $454,080 510,400

We explain why the gross profit declined by $34,990. We include a detailed variance analysis of price changes and changes in volume for sales and cost. Also, we subdivide the total volume variance into changes in price and changes in quantity. Sales price and sales volume variances measure the impact on the firm’s CM (or GM) of changes in the unit selling price and sales volume. In computing these variances, all costs are held constant in order to stress changes in price and volume. Cost price and cost volume variances are computed in the same manner, holding price and volume constant. All these variances for the Lake Tahoe Ski Store are computed next. Sales Price Variance Actual Sales for 20X2: Model X 2,650 $160 = $424,000 Model Y 2,900 176 = 510,400

$934,400

Actual 20 2 sales at 20X1 prices: Model X 2,650 $150 = $397,500 Model Y 2,900 172 = 498,800

$896,300 $ 38,100 F

Sales Volume Variance Actual 20 2 sales at 20X1 prices:

$896,300

Actual 20 1 sales (at 20X1 prices): Model X 2,800 $150 = $420,000 Model Y 2,640 172 = 454,080

874,080 $ 22,220 F

Cost Price Variance Actual cost of goods sold for 20X2: Model X 2,650 $125 = $331,250 Model Y 2,900 135 = 391,500

$722,750

Actual 20X2 sales at 20X1 costs: Model X 2,650 $110 = $291,500 Model Y 2,900 121 = 350,900

642,400 $ 80,350 U

Cost Volume Variance Actual 20X2 sales at 20X1 costs:

$642,400

Actual 20X1 sales (at 20X1 costs): Model X 2,800 $110 = $308,000

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Model Y 2,640 121 = 319,440

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627,440 $ 14,960 U

Total volume variance sales volume variance cost volume variance $22,250 F $14,960 U $7,260 F

The total volume variance is computed as the sum of a sales mix variance and a sales quantity variance: Sales Mix Variance

Model X Model Y

20X2 Actual Sales at 20X1 Mix*

20X2 Actual Sales at 20X2 Mix

2,857 2,693 5,550

2,650 2,900 5,550

Diff.

20X1 Gross Profit per Unit

207 U 207 F

$40 51

Variance ($) $ 8,280 U 10,557 F $ 2,277 F

*This is the 20X1 mix (used as standard or budget) proportions of 51.47% (or 1,800/5,440 51.47%) and 48.53% (or 2,640/5,440 = 48.53%) applied to the actual 20X2 sales figure of 5,550 units. Sales Quantity Variance

Model X Model Y

20X2 Actual Sales at 20X1 Mix*

20X1 Actual Sales at 20X1 Mix

2,857 2,693 5,550

2,800 2,640 5,440

Diff.

20X1 Gross Profit per Unit

57 U 53 F

$40 51

Variance ($) $2,280 F 2,703 F $4,983 F

A favorable total volume variance is due to a favorable shift in the sales mix (i.e., from Model X to Model Y) and also to a favorable increase in sales volume (by 110 units), which is shown next. Sales mix variance $2,277 F Sales quantity variance 4,983 F $7,260 F

However, there remains the decrease in gross profit. The decrease in gross profit of $34,990 can be explained in this way. Gains Gain due to increased sales price Loss due to increased cost Gain due to increase in units sold Gain due to shift in sales mix Hence, net decrease in gross profit $80,350 $45,360

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Losses

$38,100 F 80,350 U 4,983 F 2,277 F $45,360 F

$80,350 U $34,990 U

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Despite the increase in sales price and volume and the favorable shift in sales mix, the Lake Tahoe Ski Store ended up losing $34,990, compared to 20X1. The major reason for this comparative loss was the tremendous increase in cost of goods sold, as indicated by an unfavorable cost price variance of $80,350. The costs for both Model X and Model Y went up quite significantly over 20X1. The store has to take a close look at the cost picture. Even though only variable costs were included in cost of goods sold per unit, both variable and fixed costs should be analyzed in an effort to cut down on controllable costs. In doing that, it is essential that responsibility be clearly fixed to given individuals. In a retail business like the Lake Tahoe Ski Store, operating expenses such as advertising and payroll of store employees must also be closely scrutinized. Example 12 (Sales Mix and Quantity Variances) Shim and Siegel, Inc., sells two products, C and D. Product C has a budgeted unit CM (contribution margin) of $3 and Product D has a budgeted unit CM of $6. The budget for a recent month called for sales of 3,000 units of C and 9,000 units of D, for a total of 12,000 units. Actual sales totaled 12,200 units, 4,700 of C, and 7,500 of D. We compute the sales volume variance and break this variance down into the sales quantity variance and sales mix variance. Shim and Siegel’s sales volume variance is computed next. As we can see, while total unit sales increased by 200 units, the shift in sales mix resulted in a $3,900 unfavorable sales volume variance. Sales Volume Variance

Product C Product D

Actual Sales at Actual Mix

Standard Sales at Budget Mix

4,700 7,500 12,200

3,000 9,000 12,200

Difference

Budgeted CM per Unit

1,700 F 1,500 U

$3 6

Variance ($) $5,100 F 9,000 U $ 3,900 U

In multiproduct firms, the sales volume variance is further divided into a sales quantity variance and a sales mix variance. The computations of these variances are shown next. Sales Quantity Variance

Product C Product D

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Actual Sales at Budgeted Mix

Standard Sales at Budgeted Mix

3,050 9,150 12,200

3,000 9,000 12,000

Difference 50 F 150 F

Standard CM per Unit $3 6

Variance ($) $ 150 F 900 F $1,050 F

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Sales Mix Variance

Product C Product D

Actual Sales at Budgeted Mix

Actual Sales at Actual Mix

3,050 9,150 12,200

4,700 7,150 12,200

Difference

Standard CM per Unit

1,650 F 1,650 U

$3 6

Variance ($) $4,950 F 9,900 U $4,950 F

The sales quantity variance reflects the impact on the CM or GM (gross margin) of deviations from the standard sales volume, whereas the sales mix variance measures the impact on the CM of deviations from the budgeted mix. In the case of Shim and Siegel, Inc., the sales quantity variance came out to be favorable—$1,050 F—and the sales mix variance came out to be unfavorable— $4,950 U. These variances indicate that while there was favorable increase in sales volume by 200 units, it was obtained by an unfavorable shift in the sales mix, that is, a shift from Product D, with a high margin, to product C, with a low margin. Note that the sales volume variance of $3,900 U is the algebraic sum of two variances: Sales quantity variance Sales mix variance

$1,050 F 4,950 U $3,900 U

In conclusion, the product emphasis on high margin sales is often a key to success for multiproduct firms. Increasing sales volume is one side of the story, selling the more profitable products is another. In view of the fact that Shim and Siegel, Inc., experienced an unfavorable sales volume variance of $3,900 due to an unfavorable (or less profitable) mix in the sales volume, the company is advised to put more emphasis on increasing the sale of Product D. In doing that the company might wish to take four steps: 1. Increase the advertising budget for succeeding periods to boost Product D sales. 2. Set up a bonus plan in such a way that the commission is based on quantities sold rather than higher rates for higher-margin item such as Product D or revise the bonus plan to consider the sale of Product D. 3. Offer a more lenient credit term for Product D to encourage its sale. 4. Reduce the price of Product D enough to maintain the present profitable mix while increasing the sale of product. This strategy must take into account the price elasticity of demand for Product D.

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Nonmanufacturing Activities When nonmanufacturing activities repeat and result in a homogeneous product, standards may be used. The manner of estimating and employing standards can be similar to that applicable with a manufactured product. For instance, standards may be used for office personnel involved in processing sales orders and a standard unit expense for processing a sales order may be derived. The variance between the actual cost of processing a sales order with the standard cost can be appraised by sales managers and corrective steps taken. The number of payroll checks prepared should be a reliable measure of the activity of the payroll department. The number of invoices or vouchers prepared apply to billing and accounts payable. In these two cases, a standard cost per unit could be based on the variable expenses involved. Variance analysis is used in non-production-oriented companies such as service businesses. Because we are not dealing with a product, a measure of volume other than units is necessary, for example, time spent. The measure of revenue is fee income. The cost variances are still the same as in a manufacturing concern, namely budgeted costs versus actual costs. We also can derive the gross margin or contribution margin variance as the difference between that budgeted and that actually obtained. The profitability measures are expressed as a percent of sales rather than as dollars per unit. The relationship between costs and sales often is highlighted. Service firms typically have numerous variances expressed in physical, rather than dollar, measures. Examples of physical measures are number of customers serviced and turnover rate in customers.

Illustrative Variance Analysis Report for a Service Business For a service business, cost variances may be reported in special reports. For example, the variance in time and cost spent for processing payments to creditors may be analyzed. An illustrative format follows. Variance in Time

Variance in Cost

Function Processing purchase orders Processing receiving reports Processing vendors’ invoices Preparing checks Filing paid vouchers and supporting documents

Variances for these functions are useful only for large companies where the volume of activity allows for the arrangement and analysis of such repetitive tasks.

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Variances to Evaluate Marketing Effort Prior to setting a marketing standard in a given trade territory, examine prior, current, and forecasted conditions for the company itself and that given geographical area. Standards will vary, depending on geographical location. In formulating standard costs for the transportation function, minimum cost traffic routes should be selected on the basis of the given distribution pattern. Standards for advertising cost in particular territories will vary depending on the types of advertising media needed, which are in turn based on the type of customers the advertising is intended to reach, as well as the nature of the competition. Some direct selling costs can be standardized, such as product presentations for which a standard time per sales call can be established. Direct selling expenses should be related to distance traveled and frequency of calls made. If sales commissions are based on sales generated, standards can be based on a percentage of net sales. Time and motion studies are usually a better way of establishing standards than prior performance, because the past may include inefficiencies. Cost variances for the selling function may pertain to the territory, product, or personnel. Variances in Selling Expenses The control of selling expenses is not as significant for a company manufacturing a standard line of products with a limited number of established customers as for a manufacturer of custom products in a very competitive market. For the latter, significant advertising and salespeople costs are mandated. The variance in selling costs is equal to the actual cost versus the flexible budgeted cost. Assume actual cost is $88,000 and the flexible budget is: $40,000 (5% sales revenue) ($.03 per unit shipped)

If sales revenue is $500,000 and 100,000 units are shipped, the flexible budgeted cost is: $40,000 (5% $500,000) + ($.03 100,000 units) $68,000

The variance is unfavorable by $20,000. Perhaps advertising and travel should be investigated further. These costs are highly discretionary in that they may easily be altered by marketing managers. Further refinement of the selling expense variance is possible. Each element of selling expense (i.e., advertising, travel, commissions, shipping costs) could be looked at in terms of the difference between budgeted cost and actual cost.

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Sales Personnel Performance Actual sales may not be the best measure of sales personnel performance. It does not take into account differing territory potentials. Also, a high-volume salesperson may have to absorb high selling cost, making the profit generated low. Profit is what counts, not sales. The evaluation of sales personnel based on the trend in their sales generated over the years shows signs of improvement. However, not considered here are customer ’s market demand, potential markets, product mix, and cost incurrence. Travel expense standards often are formulated on the basis of distance traveled and the frequency of customer calls. Standards for salesperson automobile expense may be in terms of cost per mile traveled and cost per day. Entertainment and gift expenditures can be based on the amount, size, and potential for customers. The standard might relate to cost per customer or cost per dollar of net sales. Selling expense standards are frowned on by sales managers because they may create ill will among sales personnel. The standards also do not take into account sales volume or product mix. Profitability per salesperson may be a good measurement yardstick. Sales, less variable product costs, less selling expenses, per salesperson will give the relevant profitability. Not considered here, however, are territory expectations or territory demand. Standard costing procedures and performance measures should be used to control sales personnel costs and compute earnings generated by salesperson category. Further, revenue, cost, and profit by type of sales solicitation (i.e., personal visit, telephone call, mail) should be determined. A break-even analysis for individual salespeople also may be performed. Sales commissions should be higher for higher-profit merchandise. Any quotas established should be based on a desired sales mix. Consideration of fixed versus variable costs for a function is critical in marketing cost control and in deciding whether to add or drop sales regions and product lines. Fixed marketing costs include administrative salaries, wages of warehousing and shipping personnel, rent, and insurance. Variable marketing costs are comprised of processing, storing, and shipping goods, which tend to fluctuate with sales volume. Also of a variable nature are sales personnel salaries and commissions as well as travel and entertainment. It is difficult to project marketing costs because they may change materially as market conditions are altered. An example is a modification in the channels of distribution. Also, customer brand loyalty is difficult to predict. The point here is that it is more difficult to forecast and analyze marketing costs than manufacturing costs. Thus, standards established in this area are quite tentative and very difficult to manage.

Illustrative Marketing Performance Report An illustrative format for a marketing performance report designed for the marketing manager follows.

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Evaluating Performance Budget

Percent

Actual

Percent

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Variance

Sales Less: Standard variable cost of sales Manufacturing margin Less: Variable distribution costs Contribution margin Less: Regional fixed charges Controllable regional contribution margin Less: Marketing fixed charges (i.e., central marketing administration costs, national advertising) Marketing contribution margin

An illustrative format for a marketing performance report designed for the regional sales manager follows. Budget

Percent

Actual

Percent

Variance

Sales Less: Standard variable cost of sales Manufacturing margin Less: Variable distribution costs (i.e., sales personnel commissions, freight out) Contribution margin Less: Regional fixed charges (i.e., salesmen salaries, travel and entertainment, local advertising) Controllable regional contribution margin

The marketing manager should be responsible for standard variable cost of sales, distribution costs (i.e., packing, freight out, marketing administration) and sales. Standard variable cost of sales is used to avoid having the marketing area absorb manufacturing efficiencies and inefficiencies. An illustrative format follows. Sales Less: Standard variable cost of sales Less: Distribution costs Profitability

The profit figure constitutes the marketing efforts contribution to fixed manufacturing costs and administration costs. How to Analyze Salesperson Variances Appraise sales force effectiveness within a territory, including time spent and expenses incurred.

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Example 13 Sales data for the company follow. Standard cost Standard salesperson days Standard rate per salesperson day Actual cost Actual salesperson days Actual rate per salesperson day

$240,000 2,000 $ 120 $238,000 1,700 $ 140

Total Cost Variance Actual cost Standard cost

$238,000 240,000 $ 2,000 F

The control variance is broken down into salesperson days and salesperson costs. Variance in Salesperson Days Actual days versus standard days times standard rate per day (1,700 versus 2,000 $120)

$ 36,000 F

The variance is favorable because the territory was handled in fewer days than expected. Variance in Salesperson Costs Actual rate versus standard rate times actual days ($140 versus $120 1,700) $ 34,000 F

An unfavorable variance results because the actual rate per day is greater than the expected rate per day. Example 14 A salesperson called on 55 customers and sold each an average of $2,800 worth of merchandise. The standard number of calls is 50, and the standard sales is $2,400. Variance analysis looking at calls and sales follows. Total Variance Actual calls actual sale 55 $2,800 Standard calls standard sale 50 $2,400

$154,000 120,000 $ 34,000

The elements of the $34,000 variance are Variance in Calls Actual calls versus standard calls standard sale (55 versus 50 $2,400)

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$ 12,000

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Variance in Sales Actual calls versus standard sale standard calls ($2,800 versus $2,400 50)

$ 20,000

Joint Variance (Actual calls versus standard calls) (Actual sale versus standard sale) (55 versus 50) ($2,800 versus $2,400)

$ 2,000

Additional performance measures of sales force effectiveness include meeting sales quotas, number of orders from existing and new customers, profitability per order, and the relationship between salesperson costs and revenue obtained. The trend in the ratios of selling expense to sales, selling expense to sales volume, and selling expense to net income should be computed. Are selling expenses realistic in light of revenue generated? Are selling expenses beyond limitations, pointing to possible mismanagement and violation of controls? Variances in Warehousing Costs In warehousing, standards for direct labor may be in terms of cost per item handled, cost per pound handled, cost per order filled, and cost per shipment. Variances in warehousing costs can be calculated by looking at the cost per unit to store the merchandise and the number of orders anticipated. Example 15 This information applies to a product: Standard cost Standard orders Standard unit cost Actual cost Actual orders Actual unit cost

$12,100 5,500 $ 2.20 $14,030 6,100 $ 2.30

Total Warehousing Cost Variance Actual cost Standard cost

$14,030 12,100 $ 1,930 U

The total variance is segregated into the variance in orders and variance in cost. Variance in Orders Actual orders versus standard orders standard unit cost 6,100 versus 5,500 $2.20

$ 1,320 U

Variance in Cost Actual cost per unit versus standard cost per unit actual orders $2.30 versus $2.20 6,100)

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$ 610 U

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Variances in Administrative Expenses As business expands, there is a tendency for administrative expenses to increase proportionately and get out of line. However, central general and administrative expenses typically are of a fixed cost nature and hence there is less need to monitor these types of costs. Here comparison of budgeted to actual costs can be made quarterly or even yearly. These comparisons should be done by department or unit of responsibility. Suggested standards for administrative expenses follow. Administrative Function

Unit of Standard Measurement

Handling orders Billing Check writing Clerical Customer statements Order writing Personnel Payroll

Number of orders handled Number of invoices Number of checks written Number of items handled Number of statements Number of orders Number of employees hired Number of employees

Selling and administrative variances for nonoperating items are the responsibility of top management and staff. Such items include taxes and insurance. Performance reports may be prepared for the administrative function, such as the salaries of top executives and general department service costs such as data processing. Performance measures also may be of a nonmonetary nature, such as the number of files processed, the number of phone calls taken, and the number of invoices written. Variances between the dollar and nondollar factors can be determined and analyzed.

Capital Expenditures Variance reports are useful in controlling capital expenditures by looking at the actual versus budgeted costs as well as actual versus budgeted times for proposals at each stage of activity. Such reports enable managers to take corrective costsaving action, such as changing the construction schedule. The director of the project is held accountable for the construction cost and time budget. Component elements within the project also should be analyzed. We also can compare the expected payback period and actual payback period. This assists in measuring operational results and budgeting efficiency. Also, estimated cash flows of the project can be compared with actual cash flows.

Variance Analysis Reports Performance reports may be prepared that examine the difference between budgeted and actual figures for: ■ ■

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Production in terms of cost, quantity, and quality Sales

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Evaluating Performance ■ ■ ■ ■ ■ ■

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Profit Return on investment Turnover of assets Income per sales dollar Market share Growth rate

Variance reports raise questions rather than answering them. For example, is sales volume down because of deficiencies in sales effort or the manufacturer ’s inability to produce? Variance analysis reports may be expressed not only in dollars, but also in percentages, ratios, graphs, and narrative. Performance reports are designed to motivate nonfinancial managers and employees to change their activities and plans when variances exist. They should be terse and concentrate on potential difficulties and opportunities. A section for comments should be provided so that explanations may be given for variances. The timeliness of performance reports and detail supplied depends on the manager the report is addressed to and the nature of the costs being measured. A production manager may need daily information on the manufacturing operations, the plant manager may need only weekly data, and the vice president of manufacturing may be satisfied with monthly performance figures for each plant. As we become more distant from the actual operation, the time interval for performance evaluation lengthens. Also, as we go up the ladder, performance reports contain data in increasingly summarized form. Because performance reports depend on the organizational structure, they should be designed based on the company’s organization chart. Reports designed for a senior vice president might deal with the entire business operation of the firm and the earnings derived from it. The manufacturing manager would look at the efficiency of the production activity. The marketing manager would evaluate the selling and distribution function. A plant head would be concerned with the output and earnings generated from the plant. A department head within the plant would be concerned with the output and earnings generated from the area as well as with cost control. Performance reports should contain analytical information. To obtain it, source data such as work orders, material requisitions, and labor cards should be evaluated. Reasons for inefficiency and excessive costs should be noted, such as those due to equipment malfunction and low-quality raw materials. For labor, the productivity measurement ratio of volume output per direct labor hour should be computed. Further, the output of the individual or machine should be compared to the normal output established at the beginning of the reporting period. Operating efficiency can thus be measured. A labor efficiency ratio also can be computed, which is the variation between actual hours incurred and standard hours.

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With regard to the evaluation of the divisional manager, fixed costs are generally not controllable by the manager, but variable costs are. There are instances, however, where variable costs are controllable by those above the division manager ’s level. An example is fringe benefits. These items should be evaluated independently because the division manager has no responsibility for them. The opposite may also be true; that is, the department manager may have control over certain fixed expenses, such as lease costs. In such cases the manager should similarly be assigned responsibility, although a successor not involved in the lease negotiation may not be assigned responsibility. Appraisal of Marketing Department Revenue, cost, and profitability information should be provided by product line, customer, industry segment, geographic area, channel of distribution, type of marketing effort, and average order size. New product evaluations also should be undertaken, balancing risk with profitability. Analysis of competition in terms of strengths and weaknesses should be made. Sales force effectiveness measures also should be employed for income generated by salespeople, call frequency, sales incentives, sales personnel costs, and dollar value of orders generated per hours spent. Promotional effectiveness measures should be employed for revenue, marketing costs, and profits before, during, and after promotional efforts, including a discussion of competitive reactions. Advertising effectiveness measures, such as sales generated based on dollar expenditure per media and media measures (i.e., audience share), are also useful. Reports discussing product warranty complaints and disposition also should be provided. Marketing costs may be broken down into selling, promotion, credit evaluation, accounting, and administration (i.e., product development, market research). Another element is physical distribution—inventory management, order processing, packaging, warehousing, shipping outbound transportation, field warehousing, and customer services. Control of marketing cost is initiated when such costs are assigned to functional groups such as geographic area, product line, and industry segment. Budgeted costs and rates should be provided and comparisons made between standard costs and actual costs at the end of the reporting period.

Conclusion Variance analysis is essential for the appraisal of all aspects of the business, including manufacturing, marketing, and service. Variances should be investigated if the benefits outweigh the costs of analyzing and correcting the source of the variance. Variance analysis reports should be in dollars and percentages. Variance analysis identifies trouble spots, highlights opportunities, encourages decision making, and fosters coordination between responsibility units.

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153

Significant unfavorable variances must be examined to ascertain whether they are controllable or uncontrollable by nonfinancial managers because they relate solely to external factors. When controllable, immediate corrective action must be undertaken to handle the problem. The manager should provide recommendations. If a variance is favorable, an examination should be made of the reasons so that corporate policy may include the positive aspects found. Further, the responsible entity for a favorable variance should be recognized and rewarded. Different degrees of significance of variances may be present, including: ■

■

■

The variance is within tolerable and normal range and thus no remedial steps are necessary. The variance is intolerable and thus either performance must be improved or new standards formulated in light of the current environment. The decision model was inappropriate, considering the goal to be achieved, and thus a more relevant model should be developed.

Reports on operating performance should show where performance varies from standard, the trend of performance, and the reasons for the variances, including the manager ’s explanation. Reporting systems differ among companies regarding the frequency and timeliness of reports, details presented, arrangement of data, employee distribution, and size of variances necessitating follow-up. Variances can be evaluated by divisions, subdivisions, departments, and cost centers. If responsibility for a variance is joint, corrective action also should be joint. If correction of an unfavorable variance involves a conflict with a corporate policy, the policy should be reevaluated and perhaps changed. If the policy is not changed, the variance should be considered uncontrollable. Even if a variance is below a cut-off percent or dollar figure, the manager may still want to investigate it if the variance is consistently unfavorable, because it may reveal a problem (e.g., poor supervision, wasteful practice). The cumulative impact of a repeated small unfavorable variance may be just as damaging as an occasional one.

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9 Manufacturing Costs Sales Forecasts and Realistic Budgets

I

n a manufacturing firm, costs are divided into two major categories, by the functional activities with which they are associated. These are manufacturing costs and nonmanufacturing costs, also called operating expenses. Manufacturing costs are subdivided into direct materials, direct labor, and factory overhead. Direct materials are all materials that become an integral part of the finished product. Examples are the steel used to make an automobile and the wood to make furniture. Glues, nails, and other minor items are called indirect materials (or supplies) and are classified as part of factory overhead, which is explained below. Direct labor is the labor directly involved in making the product. Examples of direct labor costs are the wages of workers on an assembly line and the wages of machine tool operators in a machine shop. Indirect labor, such as wages of supervisory personnel and janitors, is classified as part of factory overhead. Factory overhead includes all costs of manufacturing except direct materials and direct labor. Examples include depreciation, rent, taxes, insurance, fringe benefits, payroll taxes, and cost of idle time. Factory overhead also is called manufacturing overhead, indirect manufacturing expenses, and factory burden. In order to budget for manufacturing costs, a production budget needs to be established, which in turn requires a sales budget. Exhibit 9.1 illustrates this relationship.

Illustration To illustrate how all manufacturing cost budgets are put together, consider a manufacturing company called the Worth Company, which produces and markets a single product.

155

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Exhibit 9.1 Sales Budget/Production Budget Diagram

Sales Budget

Expected Change in Finished Goods Inventory

Production Budget

Direct Material Budget

Direct Labor Budget

Factory Overhead Budget

Sales Budget The sales budget is the starting point in preparing the manufacturing budget, because estimated sales volume influences nearly all other items appearing throughout the master budget. The sales budget should show total sales in quantity and value. The expected total sales can be break-even, target income, or sales. The budget may be analyzed further by product, territory, customer, and seasonal pattern of expected sales. Example 1 THE WORTH COMPANY Sales Budget For the Year Ending December 31, 20B Quarter 1 Expected sales in units Unit sales price Total sales

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800 $80 $64,000

2 700 $80 $56,000

3 900 $80 $72,000

4

Total

800 $80 $64,000

3,200 $80 $256,000

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Manufacturing Costs / 157

Production Budget The production budget is a statement of the output by product and is generally expressed in units. It should take into account the sales budget, plant capacity, whether stocks are to be increased or decreased, and outside purchases. The number of units expected to be manufactured to meet budgeted sales and inventory requirements is set forth in the production budget. The expected volume of production is determined by subtracting the estimated inventory at the beginning of the period from the sum of the units expected to be sold and the desired inventory at the end of the period. The production budget is illustrated next. Example 2 THE WORTH COMPANY Production Budget For the Year Ending December 31, 20B Quarter

Planned sales (Example 1) Desired ending inventory* Total needs Less: Beginning inventory‡ Units to be produced

1

2

3

4

Total

800 70 870 80 790

700 90 790 70 720

900 80 980 90 890

800 100† 900 80 820

3,200 100 3,300 80 3,220

*10 percent of the next quarter’s sales. † Estimated. ‡ The same as the previous quarter’s ending inventory.

Direct Material Budget When the level of production has been computed, a direct material budget should be constructed to show how much material will be required for production and how much material must be purchased to meet this production requirement. The purchase will depend on both expected usage of materials and inventory levels. The formula for computation of the purchase is: Purchase in units Usage Desired ending material inventory units Beginning inventory units

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Example 3 THE WORTH COMPANY Direct Material Budget For the Year Ending December 31, 20B Quarter

Units to be produced (Example 2) Material needs per unit (lbs.) Material needs for production Desired ending inventory of materials Total needs Less:Beginning inventory of materials Materials to be purchased Unit price Purchase cost

1

2

3

4

Total

790 3 2,370 216 2,586 237 2,349 $2 $4,698

720 3 2,160 267 2,427 216 2,211 $2 $4,422

890 3 2,670 246 2,916 267 2,649 $2 $5,298

820 3 2,460 250 2,710 246 2,464 $2 $4,928

3,220 3 9,660 250 9,910 237 9,673 $2 $19,346

Direct Labor Budget The production requirements as set forth in the production budget also provide the starting point for the preparation of the direct labor budget. To compute direct labor requirements, expected production volume for each period is multiplied by the number of direct labor hours required to produce a single unit. The direct labor hours to meet production requirements is then multiplied by the (standard) direct labor cost per hour to obtain budgeted total direct labor costs.

Example 4 THE WORTH COMPANY Direct Labor Budget For the Year Ending December 31, 20B Quarter

Units to be produced (Example 2) Direct labor hours per unit Total hours Direct labor cost per hour Total direct labor cost

1

2

3

4

Total

790 5 3,950 $5 $19,750

720 5 3,600 $5 $18,000

890 5 4,450 $5 $22,250

820 5 4,100 $5 $20,500

3,220 5 16,100 $5 $80,500

Factory Overhead Budget The factory overhead budget should provide a schedule of all manufacturing costs other than direct materials and direct labor. Using the contribution approach to

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budgeting requires the development of a predetermined overhead rate for the variable portion of the factory overhead. Example 5 To illustrate the factory overhead budget, assume that the cost-volume (or flexible budget) formula is: Total factory overhead budgeted $6,000 fixed (per quarter), plus $2 per hour of direct labor.

Example 5 THE WORTH COMPANY Factory Overhead Budget For the Year Ending December 31, 20B Quarter

Budgeted direct labor hours (Example 4) Variable overhead rate Variable overhead budgeted Fixed overhead budgeted Total budgeted overhead

1

2

3

4

Total

$ 3,950 $2 7,900 6,000 $13,900

$ 3,600 $2 7,200 6,000 $13,200

$ 4,450 $2 8,900 6,000 $14,900

$ 4,100 $2 8,200 6,000 $14,200

$16,100 $2 32,200 24,000 $56,200

Planning and Control of Material Purchases and Usage After determining the number of units to be produced, the company prepares the materials requirement budget and the materials purchase budget. Purchase of materials depends on production requirements and inventories. The direct materials budget involves a balancing of raw material needed for production, the raw material inventory balances, and the purchase of raw materials. The budget may provide for allowances for waste and spoilage. This section discusses the procedures for developing material budgets in more detail.

Materials Budgets The materials and inventory budgets in a typical manufacturing firm involve a determination of: ■ ■

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The quantities and cost of raw materials to be used. The quantities and value of materials to be carried in the inventory. The inventory balance depends on how long it takes to receive raw materials from suppliers after the order is placed.

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■


The quantities and cost of materials to be purchased. The amount to purchase considers expected production and raw material levels. The units of raw material needed equals the raw material usage multiplied by the units of production. In budgeting purchases, consideration should be given to expected price changes, interest cost to finance inventory, volume and cash discounts, desired delivery date, warehousing availability and cost, and obsolescence risk. The quantity and value of finished goods to be carried in the inventory

There are basically two methods of developing the inventory budget of raw materials: 1. Budget each important item separately, based on the production budget. 2. Budget materials as a whole or classes of materials based on selected production factors. Practically all companies must use both methods to some extent. Budgeting Individual Items of Material Six steps should be taken in budgeting the major individual items of materials: 1. Determine the physical units of material required for each items of goods that is to be produced during the budget period. 2. Accumulate these into total physical units of each material item required for the production plan. 3. Determine for each item of material the quantity that should be on hand periodically to provide for the production budget, with a reasonable degree of safety. 4. Deduct material inventories, which it is expected will be on hand at the beginning of the budget period, to ascertain the total quantities to be purchased. The formula for computation of the purchase is: Purchase in units Usage Desired ending material inventory units Beginning inventory units

5. Develop a purchase policy that will ensure that quantities will be on hand at the time they are needed. The purchase policy must consider such factors as economic order quantities (EOQ), economy of transportation, quantity discounts, and possible depletion of inventory. 6. Translate the inventory and purchase requirements into dollars by applying the expected prices of materials to budgeted quantities. Note: The dollar amount of purchases is one of the major cash disbursement items in the cash budget.

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Budget Based on Production Factors For those items of materials that cannot be budgeted individually, the budget must be based on production factors such as total budgeted labor hours, productive hours, standard allowed hours, cost of materials consumed, or cost of goods manufactured. Example 6 Assume that cost of materials consumed (other than basic materials, which are budgeted individually) is budgeted at $2,000,000 and that past experience demonstrates that these materials and supplies should be held to a rate of 4 times per year. Then an average inventory of $500,000 should be budgeted. This would mean that individual items of material could be held in stock about 90 days (360 days/4).

Materials Purchase Budget Illustrated The next example illustrates a typical method of budgeting the quantities and cost of raw materials to be purchased. Assume that there are three classes of materials: X, Y, and Z. Class X—Materials for which a definite quantity and monthly distribution is established in advance. Exhibit 9.2 presents standard unit information by month. Class Y—Material items for which definite quantities are established for the entire budget period but for which no definite monthly distribution program is established. Exhibit 9.3 presents unit information for items. Here the distribution to months of the total cost of $4,031 must be made on the basis of past

Exhibit 9.2 Materials Purchase Budget—Standard Unit Information by Month Item A

Units July August September October November December Total

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300 200 500 250 300 400 1,950

Standard Unit Cost $1.10 1.00 1.00 1.00 1.00 1.00

Item B

Amount

Units

Cost

$ 330 200 500 250 300 400 $1,980

650 700 400 250 350 250 2,600

$2.00 2.00 2.10 2.25 2.25 2.25

Standard Unit Amount

Total

$1,300 1,400 840 563 788 563 $5,453

$1,630 1,600 1,340 813 1,088 963 $7,433

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Exhibit 9.3 Materials Purchase Budget—Unit Information for Items Total Units Required to Be Purchased Item H I J K Total

Estimated Price per Unit

2,500 3,400 4,500 2,700 13,100

Total cost

0.25 0.34 0.23 0.45

625 1,156 1,035 1,215 $4,031

experience of budgeted production factors such as machine hours. Exhibit 9.4 presents percentage distribution information. Class Z—Miscellaneous material items that are grouped together and budgeted only in terms of total dollar purchases for the total budget period. The distribution to months is again made on the basis of past experience or production factors. The following figures may be assumed, based on budgeted machine hours (cost of Class Z materials is assumed to be $5 per hour). Exhibit 9.5 presents budgeted productive hours. Note that total purchases required for Class Z materials amount to $4,200. The total purchase budget may then be summarized as in Exhibit 9.6, which presents information by material class. The estimated days material is to be held may be computed. Assume direct material used is budgeted at $500,000 with an expected turnover rate of 4 times. Thus, the average inventory is budgeted at $125,000. Material will be stored about

Exhibit 9.4 Materials Purchase Budget—Percentage Distribution Information Percentage Distribution Based on Past Experience July August September October November December Total

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30% 20% 10% 20% 10% 10% 100%

Material Items H

I

J

K

Total

$188 $125 $ 63 $125 $ 63 $ 63 $625

$ 347 $ 231 $ 116 $ 231 $ 116 $ 116 $1,156

$ 311 $ 207 $ 104 $ 207 $ 104 $ 104 $1,035

$ 365 $ 243 $ 122 $ 243 $ 122 $ 122 $1,215

$1,209 $ 806 $ 403 $ 806 $ 403 $ 403 $4,031

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Exhibit 9.5 Materials Purchase Budget—Budgeted Production Hours Budgeted Productive Hours July August September October November December Total

Distribution to Months

150 240 175 80 95 100 840

$ 750 $1,200 $ 875 $ 400 $ 475 $ 500 $4,200

Exhibit 9.6 Materials Production Budget—Information by Material Class

July August September October November December Total

Class X Materials

Class Y Materials

Class Z Materials

Total

$1,630 1,600 1,340 813 1,088 963 $7,433

$1,209 806 403 806 403 403 $4,031

$ 750 1,200 875 400 475 500 $4,200

$ 3,589 3,606 2,618 2,019 1,966 1,866 $15,664

90 days (360/4). Material price and usage variances are discussed in Chapter 8. An illustrative budget is presented in Example 7. Example 7 XYZ COMPANY Purchases Budget For the Year Ended December 31, 20X1

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Type of Raw Material

Production

A

200,000 etc.

Ending Inventory 40,000

Beginning Inventory

Budgeted Price

Budgeted Purchase

20,000

$1.50

$330,000

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Planning and Control of Direct Labor Direct labor is paid either by piecework, in which the factory labor is paid so much per piece, or by day work, in which the labor is paid a stipulated hourly rate regardless of the job he is assigned. Planning and control of direct labor has two primary objectives: 1. To obtain the maximum output from each of the employees 2. To ensure that product costs reflect proper labor charges Planning and budgeting direct labor costs is considered straightforward for two reasons. First, direct labor operations are normally of a type for which an engineered standard can be properly set. Standard implies the amount of time it should take an average operator to perform a function under a normal operating condition. Standards are set by such means as average actual time over the years, laboratory experiment, random sampling, or a motion and time study. Second, because almost all direct labor can be identified with a specific product or job, there is relatively little difficulty in determining where and how much direct labor costs should be charged. The control function is equally clear. When actual results are reported, they are compared with the plan or target and quickly reveal when plans went astray.

Planning and Control of Factory Overhead Planning and control of overhead items have two major goals: 1. To minimize overhead costs wherever they occur 2. To make certain that overhead is allocated, in the most accurate manner, to the various jobs and products being manufactured For flexible budgeting purposes, it is important to distinguish between variable and fixed overhead expenses. Some are mixed costs that need to be divided, using such methods as the high-low method and regression analysis. For example, these cost-volume (flexible budget) formulas can be developed for various overhead items:

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Factory Overhead Costs

Formula

Electricity Maintenance Supervisors’ salaries Indirect materials Factory depreciation

$50 $10 DLH $100 $15 DLH $5,000 per month $8 per DLH $7,000 per month

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Conclusion This chapter has emphasized manufacturing budgets. The process involves developing a sales forecast and, based on its magnitude, generating production and manufacturing expense budgets needed by a specific firm. Once developed, the budgeting system provides management with a means of controlling its activities and of monitoring actual performance and comparing it to budget goals. A comprehensive profit planning and control program involves budgeting the materials and parts used in the production process. The budget process involving manufacturing expenses includes the material usage and purchase budgets, direct labor budgets, and factory overhead budgets.

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10 Marketing Budgeting for Sales, Advertising, and Distribution

B

efore presenting the budgeting aspects for a marketing department, it would be informative to review Exhibit 10.1, which shows the usual organization of a sales division. A marketing manager needs a promotion and advertising plan, selling expense plan, and marketing plan. Coordination should exist between the sales plan and the marketing plan. Sales promotion expenses should be budgeted by product, activity, media, territory, and salesperson. Authorization may be needed for unusual marketing expenditures. Direct costs are directly traceable to a nonfinancial manager’s segment, while indirect costs are general charges that are allocable in some way to each segment. The unit cost of an operation equals total expenditures divided by units of measure. The manager should consider cost per order received, cost per order filled, cost per item handled, cost per customer account, transportation cost (e.g., auto, plane, train) per month, and cost per mile by category. The number of salesperson calls and sales per call should be budgeted and then compared to actual calls and sales per call. Variances should be analyzed. The manager should determine if a large percentage of products, orders, or customers generate a small portion of sales. Marketing expenses typically increase in proportion to the amount of customer orders and products, not sales dollars. A change in sales mix can have a significant effect upon profitability. The sales manager may attempt to protect profits by increasing selling prices when costs are increasing or sales volume is decreasing. However, there are circumstances in which selling prices may not be increased because it is either impractical or prohibited. Examples are government price controls, high degree of competition (e.g., airlines), and poor economic conditions.

167

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Exhibit 10.1 Structure of a Sales Division Director of Sales

Customer Sales

Sales Promotion

Market Research

Customer Warranties and Complaints

Domestic Sales

Foreign Sales

Europe

East

West

California

Asia

North

Nevada

This chapter discusses budget preparation and analysis and control over marketing costs, including selling expenses, advertising and sales promotion, distribution costs, packaging, and travel and entertainment.

Marketing Budgets The marketing budget depends on the type of product or service, competition, market share, type of customer, costs to obtain and maintain an account, territory, anticipated sales calls, distribution channel, order size and frequency, and promotion efforts. Industry standards may be referred to when preparing marketing budgets. Budgets aid in planning sales efforts. Sales may be budgeted by product, service, customer, territory, and salesperson. Budgets should consist of sales volume and sales dollars by salesperson broken down by territory. A lump-sum appropriation may be made, consisting of a maximum amount of expenditure. Controllable and noncontrollable expenses should be identified. A budget may be based on: Type of Expenditure

Budgeting Basis

Automobile Lodging, food and telephone Other

Mileage Daily allowance Special authorization

A typical budget for a marketing division is shown in Exhibit 10.2.

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Marketing

/

169

Exhibit 10.2 Marketing Division Budget Type of Budget

Department

Current Year Quarter 1

2

3

4

Total

Prior Increase Year (Decrease)

Advertising and Promotion Project Illinois New Jersey Florida Direct Selling Administrative West East North South Total Storage and Warehouse Standard New York California Pennsylvania Michigan Administrative General and Administrative Market Research Project Customer Relations Administrative Branch Office Administrative Total

Selling Expenses Selling expenses are those that are required to make a sale (sales commissions, salesperson salaries, advertising, and sales promotion) and to distribute the merchandise to the customer (order processing, handling, storage, and delivery charges). The manager should appraise the efficiency and effectiveness of getting and filling orders. Sales may be appraised by customer, product, service, salesperson, sales method, territory, and distribution outlet. Selling effort is subject to diminishing returns because, after a certain point, additional sales volume from selling efforts do not justify the additional cost and time. Further, the sales manager should set sales personnel requirements by number and grade. The manager is responsible for the selling expense budget. The variable-fixed breakdown is highly recommended. Many selling expenses may be budgeted based on a percentage of sales, including salesperson commissions and salaries,

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sales promotion, distribution (including freight out), travel, entertainment, warranties, and training. However, some selling expenses, such as rent and advertising, may be constant or initially set by the sales manager. A fixed appropriation of selling expenses may be irreducible because a minimum amount is needed to function. Selling expenses may be budgeted, reported, and analyzed by department, division, product, service, class of customer, territory, time period (e.g., monthly), transaction, distribution outlet, sales method, and source of sale. There should be a monthly breakdown of the target selling expenses in the budget for control and monitoring purposes. There should be a budget provision for increased training costs, if additional salespeople are to be hired. Standardized activities are repetitive and subject to quantitative measurement. Examples are field selling expenses and storage handling charges. Costs should be segregated by function. The field selling expense may be based on a per-diem standard allowance. For example, auto expense may be at a standard mileage rate, telephone may be at a monthly allowance, and entertainment may be at a per-diem rate. Exhibit 10.3 graphs the ratio of selling expenses to net sales over a representative time period. Exhibit 10.4 presents an illustrative field selling expense budget. Exhibit 10.5 shows a typical monthly performance report for selling expenses broken down by responsibility.

Exhibit 10.3 Selling Expenses to Sales Selling Expenses Divided by Net Sales Percent

J

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F M A M J

J A S O N D Month

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171

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Days traveled Field Selling Expenses Food $20 per diem Lodging $100 per diem Telephone $15 per diem Valet $6 per diem Travel Airplane Railroad Auto $.30 per mile Conventions Promotions and Entertainment $50 per diem Other $10 per diem Total Expenses Selling Ratios: Cost per travel day Cost per telephone call Sales generated per call Comments:

Description

Allowance

Actual

Budget

June 20X5 Over (Under) Budget Actual

Budget

Amount

Percent

Over (Under) Budget

Cumulative

Salesperson Name and Number ___________________________________________ Sales Territory _______________________________________________

Budgeted Field Selling Expenses June 20X5

Exhibit 10.4

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Exhibit 10.5 Monthly Performance Report Sales Manager X For Month Actual

Budget

Year-to-Date Variance

Actual

Budget

Variance

If, in the monthly analysis, a selling expense item is heading over budget for the year, the nonfinancial manager notes this in the performance report, after discussing it with the responsible party. There are three options: 1. Request a revision of the target budget. 2. Request an allocation from a contingency fund, if any. 3. Take action to keep the expense on target. An illustrative budget report for a sales manager is shown in Exhibit 10.6. A typical sales engineering project budget report appears in Exhibit 10.7.

Exhibit 10.6 General Sales Manager Budget Report Current Month Actual

Over (Under) Budget

Cumulative Actual

Over (Under) Budget

Number of salespeople Costs Rent Insurance Travel Promotion and entertainment Depreciation Salaries Fringe benefits Dues Supplies Total Expenses Percentage of net sales

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173

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Project Number

Project Name

Hours

Actual Costs by Type

Budgeted Costs by Type

Sales Engineering Project Budget Report

Exhibit 10.7

Variance

Estimated Costs to Complete

Commitments

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Advertising and Sales Promotion Advertising may be local, regional, national, or international. The manager must determine how much, when, where and how advertising should be used to obtain the optimum benefit. Advertising depends on product leadership, degree of competition, market economy, and financial condition. It has to be coordinated with sales and production. Responsibility for advertising may be assigned to specific individuals, where appropriate. The major considerations in budgeting, analyzing, and controlling advertising are cost, type and number of audience, advertising frequency, consistency in meeting product, price, and distribution, and demographics. The highest percentage of a marketing budget usually is reserved for advertising. The advertising budget helps the marketing manager plan how much and where to spend. The advertising budget depends on territories, customers, products, services, activities, programs, and media. Advertising should be sufficient to accomplish objectives, such as growth rate. After the advertising budget has been determined, funds have to be assigned to specific items. The advertising budget may be broken down into departmental budgets, total budget, calendar periods, media, and sales areas. The marketing manager should set up a contingency fund so there is flexibility in the advertising budget. The fund can cover special circumstances, such as the introduction of a new product, specials available in local media, or sudden actions by competitors. The objectives of advertising are to make potential customers aware of the products or services and how to use them, improve market share, develop new markets, stimulate new products, project a favorable image and brand loyalty, counteract bad publicity, foster a negative image for competitors or counteract competition, promote sales, increase selling price, reduce selling costs, and counteract contemplated government regulation. There are various kinds of advertising, including: ■ ■ ■ ■

Promotions of a particular brand Mass advertising to a large population cross section Class of customer Message about the company in general, rather than about a specific product or service

The types of advertising media include directories (phone, etc.), print (newspapers, magazines, trade publications), direct mail, outdoor, broadcasts (television, radio), door-to-door solicitation, specialty items, and movies. Sales promotion, which is directly related to advertising, is needed for future sales. It may include special programs, store fixtures, and trade shows. Sales managers will have to justify their advertising budgets to upper management. They will have to state objectives, how to accomplish them, and the cost of each component of the program. The factors to be considered in the

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Marketing

/

175

advertising budget include profit per product, estimated advertising expense per unit, and projected additional sales volume resulting from incremental advertising expenditures. There are various ways to determine how much should be spent on advertising and sales promotion. These include arbitrary appropriation, such as that based on prior years’ advertising, all available funds, competitive parity, percentage of sales or profit, unit sales (fixed sum per unit suitable for uniform or a few products such as specialty goods), return on investment, objective-task method, and a lump sum (suitable for established products with a predictable track record and stable environment). Advertising for necessities should be expanded in recessionary years; advertising for luxuries should be emphasized in strong economic periods. Advertising may reduce direct selling costs. Let us now discuss three popular methods: 1. Percentage of sales or profit 2. Unit sales method 3. Objective-task method

Percentage of Sales or Profit With this widely used approach, advertising will be consistent with the budgeted or prior years’ revenue (e.g., five years’ average sales). Advertising also may be based on a percent of prior years’ net profit or gross margin. (Unit ⫻ Price) ⫻ Percentage Allocated or Profit ⫻ Percentage

Unit Sales Method Under this approach, a fixed sum is established for each unit of product to be sold, based on experience and trade knowledge of how much advertising is required to sell each unit. The budget basically is based on units sold instead of dollar sales. For example, if $2 is allocated for each unit of product and there are 20,000 expected units, $40,000 would be allocated to advertising.

Objective-task Method This method relates the advertising appropriation, under typical conditions and in the long run, to sales volume, so that earnings and revenue are not drained. Exhibits 10.8 and 10.9 show typical advertising budgets. There should be a comparison between successive budgeted advertising cost and anticipated incremental profit by program.

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Exhibit 10.8 Advertising and Promotion Expense Budget Amount Radio advertisements Television advertisements Newspaper advertisements Magazine advertisements Shopper advertisements Telephone advertisements and directories Catalogs Personal demonstrations Direct mail Door-to-door solicitation Samples Exhibits Total advertising and promotion expenses

Exhibit 10.9 Advertising Budget

Classification

Project Budget

Actual Expenditures

Commitment

Total

Estimated Cost to Complete

Balance Available

Exhibit 10.10 shows the impact of successive advertising outlays on earnings. Measures of advertising include: ■ ■ ■

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Trend in advertising cost to sales Advertising cost per unit sold Advertising cost per sales dollars

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177

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(2) Additional Sales Volume

10,000 15,000

(1) Additional Advertising Expenditures

$10,000 10,000

$1.50 1.40

(3) Additional Profit per Unit $1 .67

(4) ⴝ (1) ⴜ (2) Incremental Advertising Cost per Unit

Impact of Increased Advertising on Profits

Exhibit 10.10

$.50 .73

(5) ⴝ (3) ⴚ (4) Unit Incremental Profit

$5,000 10.950

(6) ⴝ (2) ⴛ (5) Profit

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Advertising cost per customer Advertising cost per transaction Advertising cost by product, media, and territory

The advertising plan should be reviewed periodically to ensure that the right products are being emphasized. For example, the sales manager would not want to promote obsolete, unsuccessful, or hazardous products. The marketing manager can evaluate the effectiveness of advertising by reviewing sales and profits before, during, and after promotion. The nonfinancial manager can monitor which customers are buying through coupons and reply cards. An analysis of competitors’ activities should be made as they affect the company. Further, cost information for advertising programs can furnish data to make decisions on future media channels. The marketing manager should appraise the effectiveness of a particular medium, such as by examining the cost per thousand (CPT). CPT is defined as the cost of advertising per thousand individuals reached by the media. Cost of Dollars Cost per Thousand ⫽ _____________________ ⫻ 1,000 Circulation in Thousands

After the marketing manager has selected an appropriate media to use, these questions should be answered: ■ ■ ■

How essential is creativity? Is there a way to buy space and time that will stretch the advertising budget? How should the product or service be positioned?

Creativity involves getting attention with color, print size, layout, and contrast. Space and time are essential if the marketing manager wants to reach the target audience. For example, what days and hours do customers watch television? If you sell sports equipment, then Saturday and Sunday are the best times. The marketing manager should properly position advertising toward those consumers most likely to buy the product and segment the market by demographics such as social class, age, gender, education, and income. Advertising standards should be established to control costs. They may be based on cost per sales dollar, cost per sales transaction, cost per account, cost per unit of space, and cost per request for information. Variances between budget and actual costs should be examined as a control measure. Exhibit 10.11 presents a variance analysis report for advertising and sales promotion. Exhibit 10.12 presents a typical budget comparing sales by brand for the current month and cumulatively. Variances between budget and actual figures are expressed in dollars and percentage. Exhibit 10.13 shows an analysis of product revenue. In comparing advertising costs to those of competing companies, reference may be made to Advertising Age.

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179

Exhibit 10.11 Budget and Actual Advertising and Sales Promotion

Media Classification

Budget

Radio Television Magazines Newspapers Displays Catalogs Direct Mail Total

$ 700 630 860 1,000 500 600 400 $4,690

Actual

Commited Funds

$ 500 400 600 800 400 500 300 $3,500

$100 150 150 100 50 50 60 $660

Total


Total Cost

Balance Available

$ 600 550 750 900 450 550 360 $4,160

$ 50 60 70 30 40 50 20 $320

$ 650 610 820 930 490 600 380 $4,480

$ 50 20 40 70 10 0 20 $210

Exhibit 10.12 Sales by Brand Month Brand

Variance

Cumulative

Budget Actual Dollar Percent Budget Actual Dollar

Percent

Brand X—Green Brand X—Yellow Brand X—Blue Total Brand X Brand Y—Red Brand Y—Orange Total Brand Y Brand Z—Small Brand Z—Regular Brand Z—Large Brand Z—Extra Large Other Brands All Brands

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Exhibit 10.13 Analysis of Product Revenue Southern Territory June 1–30, 20X1 Product W Week

Product X

Product Y

Product Z

Units Dollars Units Dollars Units Dollars Units Dollars

Total Dollars

June 1–7 June 8–14 June 15–21 June 22–30 Total Actual Total Budget Variance Units Dollars

Distribution Costs Distribution costs are costs to sell or market products in different territories. They are the costs for activities after goods are produced and until they are received by customers. Marketing managers are responsible for budgeting and controlling distribution costs, which include packaging, advertising, transportation, credit and collection, warehousing and storage, salesperson salaries and commissions, promotion, and market research. A comparison should be made of the trend in distribution costs to total costs. There should be coordination of distribution policies in the overall marketing plan, including sales promotion, advertising, direct selling, warehousing, storage, and transportation. Distribution factors and selling effort should be combined in such a way as to maximize sales and profits. There is an interrelationship between the distribution cost budget and the manufacturing and financial budgets, as well as to the sales budget. Costs should be budgeted in total and for each activity. Distribution costs and efforts should be increased in those areas providing the most profitability. For each territory, budgeted distribution costs depend on sales effort needed per dollar of cost, potential customers, buying power, population density, size of geographic area, and competition. The manager must decide how much to pay for each type of distribution and the timing and classification of distribution expenditures.

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181

Exhibit 10.14 Distribution Cost Budget Direct Selling Transportation costs Truck Rail Air Storage Market research Other Total distribution costs

$300,000 $50,000 60,000 130,000

240,000 40,000 20,000 10,000 $610,000

The distribution budget aids in coordinating distribution policies and in deriving the best combination of distribution resources, including sales volume, selling prices, and selling effort. Distribution costs should be budgeted by function or activity, territory, salesperson, program or project, product, call, and type of selling effort. They should be budgeted in absolute dollars and as a percentage of net sales. The budget promotes cost control. A typical distribution cost budget appears in Exhibit 10.14. Exhibit 10.15 presents an illustrative project budget. Distribution efforts should be based on market potential. Distribution costs may be reduced by modifying geographic areas to reduce selling cost and obtain more coverage, changing customer mix, altering distribution channels, modifying product mix, reassigning salespeople, and changing the method of sale. Costs for planning and control should be identified by responsibility, type of expenditure, order size, activity, program, territory, segment, distribution channel, and method of sale. There should be a comparison of budget to actual distribution costs. Variances should be determined and analyzed. Further, distribution costs should be compared to those in competing companies.

Analysis and Evaluation of Distribution Costs Distribution cost analysis has as its objective obtaining the optimum distribution policy. Costs should be appraised by activity or function to promote planning and control. Cost analysis may be made by product or service, segment (department, store, branch), territory (state, city, district, county), customer type, order size, distribution channel (manufacturer, wholesaler, retailer, direct to customer), sales terms (cash, installment), salesperson, method of delivery (store delivery, overthe-counter), and method of sale (mail order, company store, salesperson, house solicitation).

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Number

Name

Hours

Salaries

Other Expenses Total

Commitments

Project Budget Report

Exhibit 10.15

Estimated Cost to Complete Total Cost

Project Budget

Under or Over Budget

Marketing

/

183

There should be a comparison of each individual distribution cost to sales, such as transportation to sales. A higher ratio is unfavorable because a larger distribution expense is required for each sales dollar. Higher ratios mean less productivity. When distribution efforts are recurring and routine, it is useful to compare actual to budgeted costs for variance determination. The variances are then investigated as to cause and appropriate action taken, if needed. In addition, a comparison should be made between the distribution costs in the company to those of competing companies. The differences should be analyzed.

Control over Distribution Costs Distribution cost control involves functional responsibility and cost objectives. Costs should be assigned by responsibility center. Distribution costs by territory may be controlled by reorganizing the territory so that effort is more in line with benefits (e.g., selling expenses may be reduced with better coverage), eliminating unprofitable territories, changing the method of sale, reassigning salespeople, altering distribution channels, modifying advertising policy by territory, changing warehouse facilities, and identifying neglected customers who may buy.

Packaging Product development may take into account packaging changes and new kinds of packaging. Repackaging may be designed to save costs. The sales manager must decide on product size and form.

Travel and Entertainment The budget for travel and entertainment is prepared by the sales manager after obtaining input from salespeople. The manager should evaluate entertainment expenses. Are they proportionate to the revenue obtained by salesperson, customer, and territory?

Budget Meetings At budget meetings, the manager should present a reasonable basis for budget expectations. The manager should give an impression of being prepared, knowledgeable, and in control. A possible inconsistency in the presentation may raise doubts. For example, a manager may propose a slight budget increase in revenue because of a recession but at the same time request substantially higher expenditures because of inflation. The manager does not want to give upper management the impression he or she is rushing through the budget or has not given it sufficient preparation.

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Conclusion The marketing manager must prepare budgets for marketing costs so proper planning may occur. These costs include selling, advertising, and distribution. It is better to budget expenses based on a percentage of budgeted sales rather than on prior years’ sales. What held in the past may not hold in the current year. A thorough analysis and evaluation of marketing costs should be made to determine if they are excessive, such as by comparing each major expense category to sales. Problem areas must be identified and rectified. In this connection, the marketing manager should assign specific responsibilities to subordinates, such as salespeople, by territory or customer. If sales are increasing due to higher sales prices but sales volume is about the same, only a few marketing expenses will increase. The work volume to process orders and the delivery costs will be about the same. However, advertising and promotion costs will increase to overcome sales resistance to the higher prices. When sales volume increases, most marketing expenses increase, but they may not increase in proportion to sales volume. If the increased sales volume is from larger orders only and from existing customers, the collection, credit, and delivery costs will not increase in proportion to sales.

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11 Research and Development Budgets for a Long-term Plan

R

esearch and development (R&D) is needed to develop new products and services or to significantly improve existing ones in order to remain competitive and grow. R&D includes:

■

■ ■ ■

Conceptual formulation and design, as well as testing, in search for or evaluation of possible product or process alternatives Modification of the formulation or design of a product or process Design, construction, and testing of preproduction prototypes and models Design of tools and dies involving new technology

There should be planning and control over such R&D areas as how much to spend, what to spend it on, and how to ensure that the funds are being spent properly. R&D should be accumulated by type of expenditure, by division, by department, and by responsibility center within a department. The budget for technical departments is the sum of the total budget for all R&D activities and supporting engineering services. The nonfinancial manager must constantly appraise R&D progress, success rate, problems, risks, staff, and facilities. R&D should primarily be based on long-run goals, competition, judgment, and financial capabilities. R&D should be consistent with the goals of the division or department. Therefore, R&D should be higher for high-technology divisions. A division with older technology typically spends less on R&D and more on engineering to sustain current products and processes. Preferably, R&D should be directed toward the future rather than to maintain current products. Its objectives should be based on a division’s program. Resources may be spent for research and exploration, development, and sustainment.

185

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R&D activities should be undertaken when the return obtained from such research justifies the costs incurred and risks assumed. In addition, R&D is worthwhile if the new product can be introduced before it is already obsolete or out of favor. This chapter discusses the types of R&D costs, planning, establishing the proper funding level, preparation of R&D budgets, modifications to the budget, analysis and evaluation of R&D status, cost controls, risks associated with R&D efforts, and coordination of R&D policies within the company.

R&D Costs Direct and indirect costs are associated with R&D projects: ■

■ ■ ■ ■ ■ ■ ■ ■ ■

Personnel costs, including those of independent consultants. In general, personnel costs range between 50 to 75 percent of R&D costs. Depreciation on R&D laboratory and equipment Supplies and materials Subscriptions to journals and magazines Rentals Travel Professional membership fees and attendance at technical conferences Property taxes Outside contractor fees Cost of intangibles purchased from others

R&D Planning In R&D, individual projects have to be planned, appraised, and controlled. Any project limitations have to be noted. These items should be considered: ■ ■ ■ ■

■ ■

Progress of research efforts New and better products developed over the last 10 years The percentage of new products to total sales Average time required to proceed from the initial research stage (e.g., laboratory) to commercial production Cost/benefit of research Relationship between research and sales; comparison should be made to success of competition in research (e.g., industry norms) Exhibit 11.1 depicts the product life cycle.

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Research and Development

/

187

Exhibit 11.1 Product Life Cycle Growth

Maturity

Revenue or Profit

Introduction

Decline

Revenue

Profits

Time

Funding Level The manager must decide how much to fund research and which specific activities should be funded. The amount funded depends on how much support is needed to succeed, project priorities, number of programs desired, growth rate, size and capability of research staff, competition, trade and industry statistics, state of the economy, and political concerns. The manager should set a minimum-maximum range for R&D funding and decide what circumstances would change this range. Revised R&D calculation should be made when researchers request additional funding or time. The manager should determine if the request has merit or is a waste of additional resources. Then the manager must decide whether to support the project modification or drop the product. The manager should set a high priority to fund developmental projects, and these projects should be ranked after taking into account capital investment, expected costs, and anticipated earnings, including forecasted royalty receipts.

R&D Budget The R&D budget is based on an annual amount that the manager has decided to commit to develop new and improved products. The amount depends on the anticipated benefits based on previous efforts and success, desired growth rate, size of the division, risk and uncertainties, diversification, competition, market share,

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consumer tastes, financial resources, physical facilities, availability of raw materials, productivity, safety, reliability, price profitability, efficiency, productivity, employee number and capability, time constraints, product life cycle, stability of research program, obsolescence, and technological aspects. A budget provision is needed so engineering keeps current products from becoming out-of-date. The R&D budget may be based on: ■ ■ ■ ■ ■ ■ ■ ■ ■

■

Estimated cost of specific projects A percentage of expected sales A percentage of current year and/or prior year sales A percentage of profit A percentage of operating income A percentage of investment in capital assets A percentage of cash flow R&D per unit R&D cost per hour equal to total R&D project costs divided by chargeable hours Product life cycle

The R&D budget should take into account the expected return on sales, return on investment (ROI), payback period, discounted payback period, net present value, and internal rate of return. A comparison should be made between the estimated ROI of a research project and its actual ROI. Variances should be computed and analyzed, with corrective action taken when warranted. R&D costs should be allocated by responsibility center and then to each project or program within that segment, including support services. In preparing the budget, there should be a reconciliation of budget costs of research efforts with the total estimated cost of maintaining R&D facilities and operations. Program budgeting is research-related or applies to technical jobs applicable to programs. It typically follows a study of work performed. If a proposal involving R&D cannot be scheduled, no budget should be prepared for the entire project. Instead, there should be a step-by-step budget allocating a specific amount for research work. Once the first step is completed, a budget allotment may be made for the second step. A typical format for an R&D division budget is shown in Example 1.

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189

Example 1 R&D DIVISION BUDGET For the Year Ended December 31, 20XX Quarter 1

2

3

4

Total

Costs Controllable Salaries Professional dues Heat, light, and power Supplies Cleaning Total Noncontrollable Insurance Depreciation Taxes Total Total R&D Costs

Examples 2 and 3 present typical R&D budgets. Example 2 R&D BUDGET Materials and Supplies Laboratory Equipment Repairs Total Materials and Supplies Salaries Administrative Nonadministrative Technical staff Total salaries Other Direct Costs Membership Dues Depreciation Insurance Utilities Taxes Travel and Entertainment Total Other Direct Costs Total Research and Development

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Example 3 R&D BUDGET Project

New Staff Required

Total Man-hours

Cost

Research Electronic 5 Laser 3 Hydro 1 Completed Projects Total Research Development Tubes Gauges Testers Modes Total Development Total Project Budgets Administrative Patent Research Library General Total Administrative Grand Total

Example 4 presents a budget report.

Example 4 BUDGET REPORT Name of Department: Period: Date: Current Month Project

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Actual

Budget

Cumulative for Year Variance

Actual

Budget

Variance

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/

191

Example 5 shows an illustrative R&D cost budget. Example 5 R&D EXPENSE BUDGET Cost

Category

Actual

Latest

Estimate

Budget

Variance

Actual Cost

Variance

Estimated Cost and Hours to Complete

Budget Variance

Examples 6 and 7 present illustrative project budgets. Example 6 R&D BUDGET Budget Man-hours

Project

Actual Man-hours

Variance

Budgeted Cost

Example 7 R&D BUDGET

Project

Project Number

Man-hours

Costs

Commitments

Example 8 shows a proposed R&D budget. Example 8 PROPOSED R&D BUDGET Budget

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Employees

Man-hours

Period Cost

Cumulative Cost

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R&D risk must be appraised by product and market. There is a greater risk when a manager goes from established products and markets to new products and markets. The longer the period between R&D activity and cash flows from the project, the greater the risk.

Coordination A research project may involve coordination between several departments and their managers, who must provide input and assistance to each other. They must know how to interact, what rules to follow, and how the research will benefit their particular responsibility areas and products.

Analysis and Evaluation R&D analysis involves looking at past, current, and future projects. Each R&D project should be thoroughly analyzed in terms of marketing, production, and distribution. There should be a priority ranking so that the best R&D projects are undertaken, given the limitations of manpower, facilities, and financial resources. R&D may be related to sales, profits, production, number of employees, labor hours, number of segments, entering new markets, expansion of product lines or services, and diversification attempts. The manager must determine whether the research staff has the technical ability and resources to undertake the project successfully. The manager should evaluate where R&D funds are being used, how successful the R&D undertakings are by category and type, where additional funding should be placed because of potential opportunities, and where less funding should be made because of unsuccessful and problem programs. He or she should evaluate R&D on a recurring, periodic basis, such as quarterly or semiannually. Projects having greater uncertainty or risk may be evaluated more frequently, such as monthly. The manager should prepare a project screening report evaluating proposed R&D in terms of marketing, production, technical, safety, and legal and financial aspects. There should be progress points to appraise and track R&D efforts. Performance standards for research should be used and compared to actual performance. These standards include number of patents received, cost per patent, cost per operation, cost per hour, number of tests and formulas, number of requisitions, and research hours by activity. There should be a comparison between the actual costs incurred by program or activity to the funds budgeted for each R&D program or activity. The manager should keep track of: ■ ■ ■

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R&D to net sales R&D by product Expected rates of return

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Research and Development ■ ■ ■ ■

/

193

Estimated project costs Salaries to man-hours Average R&D projects per period Research commitments

R&D employees (engineers, scientists) should be required to keep time sheets of hours spent by project, because a high percentage of R&D cost is labor. Research programming examines research fields to be investigated and the depth of such coverage. There should be periodic R&D status reports presenting objectives, potential, priority classification, technical achievements, amount of expenditures, and schedule of conformance. Exhibits 11.2, 11.3, and 11.4 present R&D status reports.

Control over R&D R&D is project-oriented, and costs are accumulated by project. Due to the long duration of a project, adequate project control must exist to accumulate all costs from start-up to the finished product. Further, R&D projects cannot be measured by quantity, volume-driven factors, or money that has been or has not been spent. For example, 75 percent of the money may have already been spent on the project, but that does not mean the project is 75 percent complete. R&D expenditures should be in conformity with budget limitations. There should be project controls. Control reports are required by commitment and expenditure. In the control phase, there should be a comparison between the technical and financial aspects of projects. Projects should be continually appraised to determine which ones should be expanded, dropped, modified, or deferred. A significant degree of cost control should be placed over high-risk R&D projects.

R&D Risk The risk must be analyzed. If there has been a high failure rate in R&D, proposed projects will have to be examined very closely. Have R&D projects in past years been completed at budget dollar amounts and within expected time periods? What has caused cost overruns and time delays? Do problems still exist or have they been rectified?

Conclusion Research is defined as the testing in search for a product, while development means translating that research into a design for the new product. R&D may be classified as new products, enhancements to current products, projects requested by salespeople and marketing, projects requested by the factory, and fundamental projects having no immediate commercial use.

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194

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Fundamental Research Project L Project M Total

Sales Revenue Project P Project Q Total

New Product Research Project X Project Y Project Z Total

Product Improvements Project A Project B Project C Project D Total

Project

Project Identifier

Manhours

Other Salaries Expense

Month

Total

ManPurchase hours Amount Commitments

Cumulative to Date

Project Status Report

Exhibit 11.2

Manhours Amount


Total Cost

Project Budget

Cost (Over) or Under


/

195

Exhibit 11.3 R&D Project Status Report Month Project ManNumber hours

Expenditures

Cumulative to Date Manhours

Expenditures

Commitments

Budget

Cost Overun

The manager should continually appraise R&D programs. If a specific R&D project has excessive costs and delays, the feasibility of that project may be questionable. The manager must decide on where to direct R&D efforts and how much to spend. The best alternative project must be selected and the progress on the project closely monitored.

Exhibit 11.4 Project Status Report

Project Name: Account Number: Date Started: Estimated Completion Date: Priority Code: Total Estimated Cost: Review Date: Budget: Actual: Status: Progress and Accomplishments: Recommendations and Comments:

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12 General and Administrative Costs Budgets for Maximum Productivity

T

he nonfinancial manager may identify general and administrative expenses by a particular function, activity, product line, service, segment, unit or other responsibility center. Managers may be assigned responsibility for administrative costs. Administrative departments include general administration, personnel, legal, insurance, and computer services. Examples of administrative expenses are executive and office salaries, office rent, office expenses, legal expenses, and dues. This chapter discusses the budget process, analysis and evaluation of costs, cost control, and employee considerations.

Budget Process The manager may budget general and administrative expenses based on specific plans and programs. Because most administrative expenses are fixed, an analysis of the historical record typically will provide a sound basis to budget them. The variable-fixed breakdown is highly recommended. The budgeting of administrative expenses is difficult to plan and control. One approach is to establish acceptable ranges of costs as percentages of revenue to achieve target earnings. Another is to review administrative costs and determine how much should be allocated to each area by using historical data. It is worthwhile to break general and administrative expenses into discretionary and nondiscretionary costs. Discretionary costs, such as bonuses, are those that are not essential to satisfy short-term business goals. These costs are usually targets for cutting when costs need to be reduced. The manager may budget rent simply by using the monthly rent figure. This figure should include an adjustment for cost of living increases, property taxes, and rent escalation clauses. 197

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Exhibit 12.1 Department Budget Department name and number: Department manager: Period:

Item

Budgeted Cost

Actual Cost

Variance

Percent of Variance to Budget

In budgeting salaries, multiply the number of employees by their monthly salaries. There should be included a provision for salary increase, sick leave time, vacation, holidays, and fringe benefits. In budgeting taxes and licenses, use a historical percentage rate. Research city, state, and federal sources for potential increases. Divide by 12 months and apply it to each month of the budget. Payroll taxes can be approximated by taking a percentage between 10 and 15 percent of the gross payroll cost as the monthly budget. In budgeting travel costs, determine what trips will be taken, where they will be taken, and who will be going. If only modest trips can be taken, divide the total annual dollars by 12 to determine the monthly budget. If extensive traveling is involved, calculate each month separately by the actual expected trips for that month. A departmental budget for general and administrative expenses appears in Exhibit 12.1 It is advisable to base budgeted administrative expenses on specific plans and programs. Past experience, adjusted for anticipated changes in management policy and general economic conditions, is helpful. Because most administrative expenses are fixed, an analysis of the historical record will often provide a sound basis for budgeting them. The concept of flexible expense budgets has not been widely accepted for controlling administrative expenses, but there is seldom any practical reason for not applying the concept to these expenses. The fact that most of the administrative expenses are fixed simplifies the application of flexible budgets. Headcount Forecasting In the nonmanufacturing functions of a business (such as general administration, R&D, marketing, and product engineering), the most significant expense usually is salaries. Some companies have developed formal procedures for projecting

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General and Administrative Costs

/

199

and controlling such expenses. These methods are known as headcount forecast algorithms. The methods used by Intel Corporation, described in the following excerpt from a Management Accounting article, are typical.

Headcount Forecast Algorithms1 How do you control indirect costs in a dynamic environment? One answer is an indirect headcount (cost) algorithm. The headcount algorithm is a systematic method that helps managers evaluate requests for additional staffing of indirect product specialists or heads and at the same time control indirect costs and improve productivity. Intel managers found it especially helpful when considering the reallocation of resources among rapidly expanding or contracting product groups. The concept of using algorithms to control costs is not new. Management accountants use similar algorithms to control variable expenses. For example, the flexible budget typically adjusts the allowance for variable indirect costs based upon some measure of manufacturing activity. Control is enhanced when actual costs are compared with the flexible budget allowance for the level of volume actually experienced. As the operations become more capital intensive and indirect fixed costs become a larger segment of the total expenses controls that focus on variable indirect costs are no longer adequate. At Intel a major component of indirect costs is salaries for marketing and other product support groups. Traditionally, such cost pools have been considered fixed costs. However, the headcount algorithm treats these costs essentially as step variable costs and attempts to establish target spending levels as a function of multiple volume measures and other significant characteristics of each product group. As the company became more capital intensive indirect expenses began to represent a larger segment of total expenses and the company decided it was time to exercise more control over the staffing of nonproduction areas of the company’s operations. Top management became committed to the development of a method to forecast manpower needs. Before deciding on the basic algorithm approach, management considered and rejected other models. Regression analysis and time series analysis were ruled out because of a lack of historical data and a rapidly changing future environment. The headcount algorithm was selected because it is simple understandable and at the same time realistic. Managers are able to use it to effectively measure productivity in the nonproduction areas, including consumer marketing and technical marketing engineering, and product engineering. The basic approach to forecasting algorithms is a weighted average of forecasted indicators divided by their targets N

Headcount Forecast = ∑ i =1

Weight i x Forecast indicator i Indicator Target

1

Michael Gilchrist, Diane D. Pattison, and Ronald J. Kudla, “Controlling Indirect Costs with Head-count Forecast Algorithms,” Management Accounting, August 1985, pp. 47–48.

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At Intel the indicators targets and weights were determined from in-depth interviews with customer marketing engineers (CME) and technical marketing engineers, as well as with product engineers. During these interviews the engineers identified several predictors for manpower needs including: sales revenue, volume, product maturity and development, and market segment For example, the CMEs agreed that for their area of operation the major indicators for headcount were revenue, new products, and total products. These items were then incorporated into the algorithm. Further analysis revealed that the most important of these three indicators was revenue; new products and total products were of less but equal importance.

Analysis and Evaluation Budgeted expenses should be documented as to how the amounts are derived and the source of information. Costs should be evaluated by type. They should be compared to sales over the years and to competing companies. If cost increases are substantially disproportionate to sales or production, the reasons must be found and, if necessary, corrective action taken. Costs may also be related to direct labor hours, operating income, and number of transactions. Many administrative costs are not subject to specific measurement, standardization, or predication. The manager should consider how many employees answer to him or her, what their job responsibilities are, and what objectives are to be met. A manager in the engineering area should segregate the budget into suitable categories, such as product enhancement, operating difficulties, and cost reduction. The deadline dates for each major work stage should be stated.

Cost Control Cost controls must exist, and there should be a balance between costs and sales. Maximum percentages by which certain costs cannot exceed sales may be set (e.g., 15 percent of sales). Costs may be reduced by eliminating duplicate or unnecessary activities.

Employees Specific individuals should be assigned responsibility and control of general and administrative expenses. Further, there should be a balance in workload among employees. Employee bonuses and incentives should be based on earnings.

Conclusion Productivity always must be maintained in the administrative area, so the manager should exercise tight supervision. The general and administrative expense budget should be carefully prepared and analyzed, taking into account past history and the current environment.

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13 Capital Expenditures Assets to Be Bought, Sold, and Discarded

C

apital expenditures should be consistent with the long-term plan of the company. They may be for generating earnings by providing additional revenue or reducing costs, such as when the purchase of more efficient equipment and machinery results in lower maintenance expenditures. They should generate an adequate return, and therefore a desired return on investment should be set. Capital expenditures include replacing machinery to economize on costs, expanding production to increase volume, marketing of a new product, improving the quality of products or services, and manufacturing under proposed contracts. Capital expenditures should take into account current and needed facilities. Commitments also must be considered. The capital expenditure budget reveals how much is required to invest in capital assets to meet the nonfinancial manager ’s objectives, so that the division or department can function properly. The budget breaks down the capital assets by major category, how much funding is needed, when that funding is required, the location of the assets, and pertinent reasons and comments. The timing, nature, and adequacy of capital expenditures have a long-term impact on the manager ’s responsibility center. Capital expenditures may be incurred because of growth, increased sales, increased production, changes in production methods, change in style, cost reduction, efficiency and effectiveness, productivity, improvement in product quality, new business, normal replacement, preventive maintenance, and counteracting competition. The capital expenditure budget depends on such factors as future potential, return on investment, sales, profitability, productivity and efficiency, capacity utilization, payback period (how many years it takes to get the initial investment back), timing of needed capital expenditures, risk, technological obsolescence, 201

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diversification, safety concerns, financial position including cash flow, tax benefit and other government incentives, market share, new product development, maintenance and repair requirements, problem areas, replacement options, nature of industry, economic conditions, political factors, and laws and regulations (e.g., pollution requirements, restrictive uses on assets). There are uncertain benefits for capital expenditures because of the significant cash outlay and long time period involved. In fact, if for some reason a capital expenditure fails, a significant loss is likely. The manager should prepare the capital expenditure budget needed for his or her responsibility unit after consulting with engineering and technical staff. A capital asset cannot be bought unless it has been included in the capital budget. Capital assets include equipment, furniture, machinery, storage facilities, distribution facilities, and computers. The manager should approve capital expenditures only after detailed study and justification and, after that, continual monitoring and control are recommended. The manager should set up a priority listing of capital projects based on earnings or strategic importance. The planning should take into account the peculiar characteristics and nature of the industry and company. Duplication in capital expenditures results in inefficiency and excessive costs. Control is in the form of comparing budgeted expenditures to actual expenditures. The trend in the ratio of insurance expense to the carrying value of the capital assets, and the insured value relative to replacement cost, will indicate the adequacy of insurance protection. The timing of capital expenditures depends on available alternatives, startup time, and funds. The manager must identify capital expenditures that are not essential, can be delayed for a reasonable time, or are urgently needed. Some capital expenditures result in profit reductions, such as outlays that are required by law, that improve research and development, and that enhance employee morale. Some capital expenditures are required by government, such as for employee safety and to conform to building codes. This chapter discusses the budget process, authorization of capital budgets, capital budget forms and reports (including special reports), budget revisions, analysis and evaluation of capital expenditures, and controls.

Budget Process For budgeting, capital expenditures may be classified as normal or special. Normal expenditures are routine, less costly, and made to maintain current operations. Each project typically does not involve a large cash outlay. The normal capital expenditure should meet the needs of the manager ’s division or department. An example is a minor replacement of machinery. Special capital expenditures are unusual, costly, and made for a specific purpose, such as the purchase of a new machine to manufacture a product for a special job of a one-time nature.

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Capital Expenditures / 203

Major capital projects typically are planned and proposed by operating managers and must be approved by upper management. The manager must properly budget and package the capital expenditure. These expenditures must be classified by category, class, need, consequence, and feasibility. Capital expenditures may be required or optional. In the case of minor capital expenditures, the division and department managers may have the authority to approve them on their own. The four steps in the capital expenditure budgetary process are: 1. 2. 3. 4.

Approving the project Approving the estimate Authorizing the project Follow-up

The capital expenditure proposal should contain a description, starting date, completion date, source information, and advantages and disadvantages of the proposal. Some capital expenditures are minor and not subject to detailed planning. Examples are low-cost machinery and minor renovations. These minor expenditures may be lumped together with a blanket appropriation. Capital expenditure policy should take into account: ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■

Desired rate of return Cost impact Age of existing assets Expected capacity of the item Asset life Growth potential Employee availability Competition Stage of the business cycle Legal liability exposure Regulatory requirements

The manager should set a priority ranking for capital expenditures in terms of operating necessities and nonnecessities. These dates should be noted: ■ ■ ■

Dates manpower will be available Marketing schedules for products to be produced Delivery dates when items are needed

A current capital budget usually covers three to five years in annual segments of planned capital expenditures.

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Authorization of Capital Budget If capital expenditures exceed authorized limits, special approval by top management is required. A project not meeting expectations or that is no longer appropriate, given current circumstances, may be canceled. It is better to cancel a project if the cost/benefit relationship indicates that the project is no longer viable. If a project is a succession of individual projects, a partial authorization may be made. Exhibit 13.1 is an illustrative capital budget request schedule form. An authorization form should be filled out for approved capital expenditures. The reason and purpose of the expenditure should be given. Exhibits 13.2 and 13.3 are illustrative authorization forms. The amount authorized should be compared periodically to actual costs incurred. In addition, commitments must be recorded and monitored because ultimately the total appropriated amount may be exceeded. The estimated cost to complete also should be noted along with any expected overruns or underruns.

Capital Budget Forms Request forms should be completed and approved for capital expenditures. A commitment record contains the purchase orders issued. An appropriation form for capital expenditures provides information on the benefits to be obtained from the proposed project and the expected cost savings. The authorization sets forth the type and scope of the project. Exhibit 13.4 is a typical annual capital budget request form. Exhibit 13.5 is an illustrative preliminary budget request form. An appropriation request form is filled out by the manager of the responsibility unit in detail, providing justification to support the capital proposal. The manager must thoroughly appraise the proposed capital project. A proposal form for capital expenditures may include title of project, project objectives, description of project, proposed budget, analysis and evaluation, supporting documentation and calculations, justification, and time estimates. Exhibits 13.6, 13.7, and 13.8 present typical appropriation request forms. A capital budget form summarizes proposed capital projects for the period by responsibility center. Exhibit 13.9 presents an illustrative capital budget form.

Capital Budget The capital asset budget includes beginning balance, additions, deletions, depreciation, construction in progress, and ending balance. The budget format should include category, class, project title, project number, project life, capital costs, and return on investment. The budget should contain a provision for explanatory comments. Extraordinary repairs are usually included in the capital expenditure budget but ordinary repairs are included in the expense budget. The production budget may require capital additions. Exhibits 13.10 to 13.16 present illustrative capital budgets.

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205

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Contingency Funding Total

Minimal but Recommended Lift Trucks Landscaping Roofing

Growth and Expansion DEF Recovery System LMN Plant

Replacements

Need to Maintain Competitive Position Quality Control Facility Color Retention

Absolutely Required Air Pollution Conveyer Grinder Crusher

Description

20X5 This Year

Appropriations

20X4 Previous Year ROI

Total Commited Amount 20X4

ABC Company Annual Capital Budget Request 20X5

Exhibit 13.1

20X5

20X6

20X7 and Later

Total

Expected Capital Expenditures

206 /


Exhibit 13.2 Capital Expenditure Authorization Division Name: Division Number: Location: Date: Reason for Authorization: Estimated Total Cost: Item Requested: Description: Estimated Cost Breakdown: Comments and Recommendations: Approved

Rejected

Date

Reason

Requested by: Approved by:

Exhibit 13.3 Capital Expenditure Authorization Division: Plant:

Date:

The capital expenditure is needed because of: (Check appropriate item) ______ New product ______ Normal replacement ______ Modification in production process ______ Cost reduction

______ Increased sales volume ______ New quality control standards ______ Style change

Description and justification Estimated Cost Material Labor Overhead Contingency Total Cost Expected Return on Investment Payback Period Life Construction Period Disposal Value Manager ’s Comments and Recommendations: Requested by: Approved by:

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Exhibit 13.4 Annual Capital Budget Request Form Description

Appropriations

Capital

Expenditures

Future Commitments

Exhibit 13.5 Preliminary Budget Request Information Division Name: Department Name: Division Number: Department Number: Responsible Individuals: Project Classification: Original Request or Supplementary Request: Funds Requested: Proposal Description: Time Schedule: Beginning Date: Expected Ending Date:

Date:

Expected Benefits: Priority Level: Expected Return: Approvals

Exhibit 13.6 Appropriation Request Form Division: Department: Responsibility Unit:

Project Description: Project Location:

Expected Expenditures Initial Request Amount Amount Approved to Date Future Request Total Project Cost Return on Investment Payback Period: Net Present Value: Internal Rate of Return: Background Information: Recommendations: Classifications: Nature of Capital Project Proposal:

207

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Exhibit 13.7 Preliminary Budget Request Information Date Division Name: Division Number:

Department Name: Department Number:

Type of Capital Expenditure New Cost Reduction Expansion Other (Description) Replacement Request Initial Supplementary Priority Classification Proposal Description Identification of Capital Expenditure Expected Rate of Return Expected Cash Flows (net) Time Schedule Approvals Department Manager: Division Manager: Vice President:

Date: Date: Date:

Comments

Exhibit 13.8 Capital Expenditures Request Form Responsibility Unit Name: Responsibility Unit Number: Time Period: Description

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Quantity

Justification

Budgeted

Cost

Date of Purchase

Prepared by:

Date:

Approved by:

Date:

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Exhibit 13.9 Capital Budget Form

Department Item

Item Total Description Number Status Expenditure

Expected Rate of Return Priority Classification

Exhibit 13.10 Capital Expenditures Budget For the Year Ended December 31, 20XX Machinery Equipment Furniture and Fixtures Total

$1,500,000 800,000 200,000 $2,500,000

Exhibit 13.11 Capital Expenditures Budget Item A C Equipment Total

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To Maintain Current Operations

To Expand

Total

$300,000 100,000 150,000 $550,000

$200,000 50,000 100,000 $350,000

$500,000 150,000 250,000 $900,000

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210

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Item Number

Work Order Appropriation Number Number

Description of Job by Department Before 2005 2005 2006 2007

After 2007

Unit Projected Total Cost Classified by Date of Expenditure

Preliminary Capital Budget

Exhibit 13.12

Additional Facilities Replacements

Rehabilitation

Estimated Expenditures 2005–2007 Classified by Accounting Disposition

Repairs Other

Expense

211

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Project

Budgeted Amount

Amount Authorized

Unexpended Balance

Capital Expenditure Budget

Exhibit 13.13

Actual Expenditures

Amount Subject to Authorization

Amount Spent

212

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Proposed Replacements:

Proposed New Projects:

Approved Projects:

1

2

3

4

Amount to Be Expended by Quarter

Capital Expenditure Budget

Exhibit 13.14

Total

In Later Periods

213

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Capital Leases

Capital Expenditures

Type of Project

Carryforward Amount

New Commitments

Total Amount Available

Commitments On Previous Years’ Commitments

Capital Asset Budget Division X

Exhibit 13.15

Current Year Authorization

Expenditures

Total for Year

Carryforward to Future years

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Exhibit 13.16 Budget for Capital Assets

Classification

Amount at Beginning of Year

Additions

Subtractions

Depreciation

Amount at End of Year

Capital Expenditure Reports The capital expenditure report should contain information of the authorized amount, actual costs, committed funds, unencumbered balance, estimated cost to complete, and cost overrun (underrun). Exhibit 13.17 presents a capital expenditures process report. Exhibits 13.18 and 13.19 present typical reports showing the comparison of budgeted expenditures to actual expenditures. Exhibit 13.20 presents a capital expenditure status report. This report should be prepared periodically by the manager to keep track of a project so that analysis and control may be facilitated. A progress report should be prepared to determine if all is going as planned and what corrective action is needed, if any. A detailed evaluation of capital expenditures may not be possible when a sudden, unexpected, or important development occurs. An example is a machine breakdown resulting in a production delay on the assembly line.

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215

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Item Number

Description

Approval Amount

Initial Expected Project Completion Date Incurred to Date

Balance for Completion Total

Expected Variation

Capital Expenditures In-process Report

Exhibit 13.17

Favorable or Unfavorable

Expected Completion Date

Comments

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Exhibit 13.18 Year-to-date Comparisons of Budget to Actual Capital Expenditures

Type

Budgeted Projects

Projects Not Budgeted

Total

Amount Budgeted

Actual Expenditures

Over (Under) Budget

Exhibit 13.19 Capital Expenditures Performance Report Estimated vs. Actual Department Name: Department Number: Authorization Number: Description: Today’s Date: Date Activity Began:

Item A B

Authorized Amount

Cumulative Actual Amount

Variance

Percent

$100,000 80,000

$103,000 81,000

$3,000 1,000

3% 1.25

Reason Delay because of strike Higher prices for component parts, etc.

A capital expenditures progress report monitors each project’s progress and indicates any overruns or underruns. Exhibits 13.21 to 13.26 present representative reports.

Budget Revisions Capital budgets should be revised when errors are found or circumstances change. Revisions would be required for changes in cost estimates, unexpected developments in the economy, design changes, technological developments, action by competitors, change in divisional or departmental objectives, and casualty losses.

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Exhibit 13.20 Capital Expenditures Performance Report Information Cost Information Budgeted Amount Cumulative Actual Expenditures Committed Amounts Unexpended Amount Expected Cost to Complete Variance Between Budget and Actual Amounts Dates Date Began Expected Completion Date Days Delayed Reason for Delay Extent of Completion Percent of Time Completed to Date Percent of Cost Completed to Date Explanatory Comments Quality Unusual Occurrences and Reasons

Special Projects Special capital expenditures involve nonroutine, large cash outlays for major specific projects. An example is the purchase of new machinery to meet customer demand. Optional projects include equipment replacement, capital expansion, modified techniques, and new ventures. Capital expenditures should be consistent with the manager ’s desired return on investment.

Analysis of Capital Projects The manager should compare the expected profit to actual profit for each capital project. There should be an evaluation of the difference between budgeted and actual capital expenditures, along with justification. Some questions to be answered by managers include: Are specialized equipment and machinery required? If capacity is expanded, what impact will it have on warehouse space?

Control over Capital Expenditures The manager should control individual projects from beginning to end. Capital expenditure outlays should be documented by supplier. Contractor price quotations

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218

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Item Number

Description

Amount Approved

Expected Completion Date

Cumulative Expenditures to Date

Amount Needed for Completion Total Actual Expenditures

Capital Expenditures Progress Report

Exhibit 13.21

Budgeted Expenditures Variance

Comments

219

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Administrative Salaries Depreciation Total

Patent Legal Fees Application Fees Total

Development Salaries Traveling Other Total

Research Salaries Supplies Power Total

Department and Cost

$60,000 80,000 etc.

Authorized Amount $50,000 70,000

Cumulative Expenditures to Date $4,000 7,000

Purchase Commitments

ABC Manufacturing Company

Exhibit 13.22

$54,000 77,000

Total Expenditures and Commitments

$6,000 3,000

Balance Remaining

220

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Project Number

Description

Cumulative

Actual Expenditures

Current Month

Commitments and Expenditures to Date


Capital Expenditure Projects

Exhibit 13.23

Current Estimated Total Cost Appropriated Amount

Over/Under Appropriation

221

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Reviewer

Preparer

Comments and Recommendation:

Total Actual Amount Approved

Actual Amount Spent to Date

Division: Location: Category: Project Title: Project Number: Project Appropriation and Investment: Initial Budgeted Amount

Revised Budgeted Amount Variance

Capital Expenditure Items: ROI: Payback Period: Discounted Payback Period: Net Present Value

Capital Expenditure Project Status Report

Exhibit 13.24

Reason

222

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Number

Category

Description

Order Number

Amount Appropriated

Completion Date Estimate

Capital Expenditure Appropriation Status Report

Exhibit 13.25

Commitments

Actual Expenditures

Variance

223

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Appropriation Number

Description

Work Order Number Completion Appropriation Date

Initial Estimate

Cumulative Outstanding Actual Commitments Expenditures

Status of Capital Expenditures Appropriated

Exhibit 13.26

Estimated Cost to Complete Total Cost

Over/Under Initial Estimate

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should be reviewed for reasonableness. Competitive comparisons should be made. Contractors may be changed when cost savings arise, quality problems exist, or delivery dates are not being met.

Conclusion The capital expenditure budget lists capital assets to be purchased, sold, or discarded. Capital expenditures may be made to replace obsolete machinery or to expand and improve operations, such as expenditures for new product lines. The manager should evaluate alternative capital proposals carefully. Further, retirement of capital assets without adequate replacement may have negative long-term effects.

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14 Forecasting and Planning Reducing Risk in Decision Making

M

anagement in both private and public organizations typically operates under conditions of uncertainty or risk. Probably the most important function of business is forecasting, which is a starting point for planning and budgeting. The objective of forecasting is to reduce risk in decision making. In business, forecasts form the basis for planning capacity, production and inventory, manpower, sales and market share, finances and budgeting, research and development, and top management’s strategy. Sales forecasts are especially crucial aspects of many financial management activities, including budgets, profit planning, capital expenditure analysis, and acquisition and merger analysis. Exhibit 14.1 illustrates how sales forecasts relate to various managerial functions of business.

Who Uses Forecasts? Forecasts are needed for marketing, production, purchasing, manpower, and financial planning. Further, top management needs forecasts for planning and implementing long-term strategic objectives and planning for capital expenditures. More specifically, marketing managers use sales forecasts to determine optimal sales force allocations, set sales goals, and plan promotions and advertising. Market share, prices, and trends in new product development are also required. Production planners need forecasts in order to: ■ ■ ■ ■

Schedule production activities Order materials Establish inventory levels Plan shipments 225

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Exhibit 14.1 Sales Forecast and Managerial Functions Forecasts of Money and Credit Conditions Sales Forecast

Financial Planning

Manpower Planning

Capacity Planning

Capital Expenditure

Production Planning

Marketing Planning

Inventory Planning

Project Planning

Procurement Planning

Other areas that need forecasts include material requirements (purchasing and procurement), labor scheduling, equipment purchases, maintenance requirements, and plant capacity planning. As shown in Exhibit 14.1, as soon as the company makes sure that it has enough capacity, the production plan is developed. If the company does not have enough capacity, it will require planning and budgeting decisions for capital spending for capacity expansion. On this basis, the manager must estimate the future cash inflow and outflow. He or she must plan cash and borrowing needs for the company’s future operations. Forecasts of cash flows and the rates of expenses and revenues are needed to maintain corporate liquidity and operating efficiency. In planning for capital investments, predictions about future economic activity are required so that returns or cash inflows accruing from the investment may be estimated. Forecasts are needed for money and credit conditions and interest rates so that the cash needs of the firm may be met at the lowest possible cost. Forecasts also must be made for interest rates, to support the acquisition of new capital, the collection of accounts receivable to help in planning working capital needs, and capital equipment expenditure rates to help balance the flow of funds in the organization. Sound predictions of foreign exchange rates are increasingly important to managers of multinational companies. Long-term forecasts are needed for the planning of changes in the company’s capital structure. Decisions on issuing stock or debt to maintain the desired financial structure require forecasts of money and credit conditions.

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Forecasting and Planning

/

227

The personnel department requires a number of forecasts in planning for human resources. Workers must be hired, trained, and provided with benefits that are competitive with those available in the firm’s labor market. Also, trends that affect such variables as labor turnover, retirement age, absenteeism, and tardiness need to be forecast for planning and decision making. Managers of nonprofit institutions and public administrators also must make forecasts for budgeting purposes. Hospital administrators forecast the healthcare needs of the community. In order to do this efficiently, a projection has to be made of: ■ ■ ■

Growth in absolute size of population Changes in the number of people in various age groupings Varying medical needs these different age groups will have

Universities forecast student enrollments, cost of operations, and, in many cases, the funds to be provided by tuition and by government appropriations. The service sector, which today accounts for two-thirds of the U.S. gross domestic product, including banks, insurance companies, restaurants, and cruise ships, needs various projections for its operational and long-term strategic planning. Take a bank, for example. The bank has to forecast: ■ ■

Demands of various loans and deposits Money and credit conditions so that it can determine the cost of money it lends

Forecasting Methods The company may choose from a wide range of forecasting techniques. There are basically two approaches to forecasting, qualitative and quantitative: 1. Qualitative approach—forecasts based on judgment and opinion ■ Executive opinions ■ Delphi technique ■ Sales force polling ■ Consumer surveys 2. Quantitative approach a. Forecasts based on historical data ■ Naive methods ■ Moving average ■ Exponential smoothing ■ Trend analysis ■ Decomposition of time series

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b. Associative (causal) forecasts ■ Simple regression ■ Multiple regression ■ Econometric modeling Exhibit 14.2 summarizes the forecasting methods. The list presented in the exhibit is neither comprehensive nor exhaustive. Sophisticated time series methods such as Box-Jenkins are reserved for an advanced forecasting text. Quantitative models work superbly as long as little or no systematic change in the environment takes place. When patterns or relationships do change, by themselves, the objective models are of little use. It is here where the qualitative approach, based on human judgment, is indispensable. Because judgmental forecasting also bases forecasts on observation of existing trends, they too are subject to a number of shortcomings. The advantage, however, is that they can identify systematic change more quickly and interpret better the effect of such change on the future. We discuss the qualitative method in this chapter. Several quantitative methods, along with their illustrations, are taken up in the next two chapters.

Exhibit 14.2 Forecasting Methods

Forecasting

Quantitative (Statistical)

Markov Analysis

Qualitative (Judgmental)

Learned Behavior

Causal (Regression)

Simple

Indirect

Barometric

Time Series

Expert Opinions

Sales Force Polling

Input/ Output

Consumer Surveys

Market Surveys

Delphi Method

Econometric Moving Average

Classical Decomposition

Box-Jenkins

Multiple Exponential Smoothing

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Trend Analysis

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229

Selection of Forecasting Method The choice of a forecasting technique is influenced significantly by the stage of the product life cycle and sometimes by the firm or industry for which a decision is being made. In the beginning of the product life cycle, relatively small expenditures are made for research and market investigation. During the first phase of product introduction, these expenditures start to increase. In the rapid growth stage, considerable amounts of money are involved in the decisions, so a high level of accuracy is desirable. After the product has entered the maturity stage, the decisions are more routine, involving marketing and manufacturing. These are important considerations when determining the appropriate sales forecast technique. After evaluating the particular stages of the product and firm and industry life cycles, a further probe is necessary. Instead of selecting a forecasting technique by using whatever seems applicable, decision makers should determine what is appropriate. Some of the techniques are quite simple and rather inexpensive to develop and use. Others are extremely complex, require significant amounts of time to develop, and may be quite expensive. Some are best suited for short-term projections, others for intermediate- or long-term forecasts. What technique or techniques to select depends on six criteria: 1. What is the cost associated with developing the forecasting model, compared with potential gains resulting from its use? The choice is one of benefit-cost trade-off. 2. How complicated are the relationships that are being forecasted? 3. Is it for short-run or long-run purposes? 4. How much accuracy is desired? 5. Is there a minimum tolerance level of errors? 6. How much data are available? Techniques vary in the amount of data they require.

Qualitative Approach The qualitative (or judgmental) approach can be useful in formulating short-term forecasts and can also supplement the projections based on the use of any of the quantitative methods. Four of the better-known qualitative forecasting methods are executive opinions, the Delphi method, sales-force polling, and consumer surveys. Executive Opinions The subjective views of executives or experts from sales, production, finance, purchasing, and administration are averaged to generate a forecast about future sales. Usually this method is used in conjunction with some quantitative method,

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such as trend extrapolation. The management team modifies the resulting forecast, based on their expectations. The advantage of this approach is that the forecasting is done quickly and easily, without need of elaborate statistics. Also, the jury of executive opinions may be the only means of forecasting feasible in the absence of adequate data. The disadvantage, however, is that of “group think.” This is a set of problems inherent to those who meet as a group. Foremost among these are high cohesiveness, strong leadership, and insulation of the group. With high cohesiveness, the group becomes increasingly conforming through group pressure that helps stifle dissension and critical thought. Strong leadership fosters group pressure for unanimous opinion. Insulation of the group tends to separate the group from outside opinions, if given. Delphi Method This is a group technique in which a panel of experts are questioned individually about their perceptions of future events. The experts do not meet as a group, in order to reduce the possibility that consensus is reached because of dominant personality factors. Instead, the forecasts and accompanying arguments are summarized by an outside party and returned to the experts along with further questions. This continues until a consensus is reached. This type of method is useful and quite effective for long-range forecasting. The technique is done by questionnaire format and eliminates the disadvantages of group think. There is no committee or debate. The experts are not influenced by peer pressure to forecast a certain way, as the answer is not intended to be reached by consensus or unanimity. Low reliability is cited as the main disadvantage of the Delphi method, as well as lack of consensus from the returns. Sales Force Polling Some companies use as a forecast source salespeople who have continual contacts with customers. They believe that the salespeople who are closest to the ultimate customers may have significant insights regarding the state of the future market. Forecasts based on sales force polling may be averaged to develop a future forecast. Or they may be used to modify other quantitative and/or qualitative forecasts that have been generated internally in the company. The advantages of this forecast are: ■ ■ ■

■

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It is simple to use and understand. It uses the specialized knowledge of those closest to the action. It can place responsibility for attaining the forecast in the hands of those who most affect the actual results. The information can be broken down easily by territory, product, customer, or salesperson.

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231

The disadvantages include salespeople’s being overly optimistic or pessimistic regarding their predictions and inaccuracies due to broader economic events that are largely beyond their control. Consumer Surveys Some companies conduct their own market surveys regarding specific consumer purchases. Surveys may consist of telephone contacts, personal interviews, or questionnaires as a means of obtaining data. Extensive statistical analysis usually is applied to survey results in order to test hypotheses regarding consumer behavior. Common Features and Assumptions Inherent in Forecasting As pointed out, forecasting techniques are quite different from each other. But four features and assumptions underlie the business of forecasting. They are: 1. Forecasting techniques generally assume that the same underlying causal relationship that existed in the past will continue to prevail in the future. In other words, most of our techniques are based on historical data. 2. Forecasts are rarely perfect. Therefore, for planning purposes, allowances should be made for inaccuracies. For example, the company should always maintain a safety stock in anticipation of a sudden depletion of inventory. 3. Forecast accuracy decreases as the time period covered by the forecast (i.e., the time horizon) increases. Generally speaking, a long-term forecast tends to be more inaccurate than a short-term forecast because of the greater uncertainty. 4. Forecasts for groups of items tend to be more accurate than forecasts for individual items, because forecasting errors among items in a group tend to cancel each other out. For example, industry forecasting is more accurate than individual firm forecasting.

Steps in the Forecasting Process There are six basic steps in the forecasting process. They are: 1. Determine the what and why of the forecast and what will be needed. This will indicate the level of detail required in the forecast (e.g., forecast by region, by product), the amount of resources (e.g., computer hardware and software, manpower) that can be justified, and the level of accuracy desired. 2. Establish a time horizon, short term or long term. More specifically, project for the next year or next five years. 3. Select a forecasting technique. Refer to the criteria discussed before. 4. Gather the data and develop a forecast.

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5. Identify any assumptions that had to be made in preparing the forecast and using it. 6. Monitor the forecast to see if it is performing in a manner desired. Develop an evaluation system for this purpose. If not, go back to Step 1.

Conclusion Managers use forecasts for budgeting purposes. A forecast aids in determining volume of production, inventory needs, labor hours required, cash requirements, and financing needs. A variety of forecasting methods are available. However, consideration has to be given to cost, preparation time, accuracy, and time period. The manager must understand clearly the assumptions on which a particular forecast method is based to obtain maximum benefit.

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15 Moving Averages and Smoothing Techniques Quantitative Forecasting

T

his chapter discusses several quantitative forecasting methods. The discussion includes naive models, moving averages, and exponential smoothing. Trend analysis and regressions are covered in future chapters. Qualitative methods were described in Chapter 14.

Naive Models Naive forecasting models are based exclusively on historical observation of sales or other variables, such as earning and cash flows. They do not attempt to explain the underlying causal relationships that produce the variable being forecast. Naive models may be classified into two groups. One group consists of simple projection models. These models require inputs of data from recent observation, but no statistical analysis is performed. The second group is made up of models that while naive, are complex enough to require a computer. Traditional methods such as classical decomposition, moving average, and exponential smoothing models are some examples. The advantage is that it is inexpensive to develop, store data, and operate. The disadvantage is that it does not consider any possible causal relationships that underly the forecasted variable. A simple example of a naive type: 1. Use the actual sales of the current period as the forecast for the next period. Let us the symbol Yt+1 as the forecast value and the symbol Yt as the actual value. Then Yt+1 = Yt

233

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2. If you consider trends, then Yt+1 = Yt + (Yt – Yt-1)

This model adds the latest observed absolute period-to-period change to the most recent observed level of the variable. 3. If you want to incorporate the rate of change rather than the absolute amount, then Yt Yt+1 = Yt ____ Yt-1

Example 1 Consider these sales data: Month

20X5 Monthly Sales of Product

1 2 3 4 5 6 7 8 9 10 11 12

$3,050 2,980 3,670 2,910 3,340 4,060 4,750 5,510 5,280 5,504 5,810 6,100

We will develop forecasts for January 20X6 based on the aforementioned three models: 1. Yt+1 = Yt = $6,100 2. Yt+1 = Yt + (Yt – Yt–1) Yt 3. Yt+1 = Yt ____ Yt-1

= $6,100 + ($6,100 – $5,810) = $6,100 + $290 = $6,390

$6,100 = $6,100 ______ = $6,100 (1.05) $5,810 = $6,405

The naive models can be applied, with little need of a computer, to develop forecasts for sales, earnings, and cash flows. They must be compared with more sophisticated models, such as the regression method, for forecasting efficiency.

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Moving Averages and Smoothing Techniques

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235

Smoothing Techniques Smoothing techniques are a higher form of naive models. The two typical forms are moving averages and exponential smoothing. Moving averages are the simpler of the two.

Moving Averages Moving averages are averages that are updated as new information is received. With the moving average, a manager simply employs the most recent observations to calculate an average, which is used as the forecast for the next period.

Example 2 Assume that the marketing manager has these sales data: Date

Actual Sales (Yt )

Jan.1 2 3 4 5 6 7

46 54 53 46 58 49 54

In order to predict the sales for the seventh and eighth days of January, the manager has to pick the number of observations for averaging purposes. Let us consider two cases. One is a six-day moving average and the other is a three-day average. Case 1 46 + 54 + 53 + 46 + 58 + 49 Y7 = _______________________ = 51 6 54 + 53 + 46 + 58 + 49 + 54 _______________________ Y8 = = 52.3 6

where Y = predicted Case 2 46 + 58 + 49 Y7 = ___________ = 51 3 58 + 49 + 54 Y8 = ___________ = 53.6 3

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Budgeting Basics and Beyond Predicted Sales (Yt) Date Jan.1 2 3 4 5 6 7

Actual Sales 46 54 53 46 58 49 54

Case 1

Case 2

51 53.6 51 52.3

In terms of weights given to observations, in Case 1, the old data received a weight of 5/6 and the current observation got a weight of 1/6. In Case 2, the old data received a weight of only 2/3 while the current observation received a weight of 1/3. Thus, the marketing manager ’s choice of the number of periods to use in a moving average is a measure of the relative importance attached to old versus current data. Advantages and Disadvantages The moving average is simple to use and easy to understand. However, there are two shortcomings: 1. It requires users to retain a great deal of data and carry it along with them from forecast period to forecast period. 2. All data in the sample are weighted equally. If more recent data are more valid than older data, why not give them greater weight? The forecasting method known as exponential smoothing gets around these disadvantages. Exponential Smoothing Exponential smoothing is a popular technique for short-run forecasting by managers. It uses a weighted average of past data as the basis for a forecast. The procedure gives heaviest weight to more recent information and smaller weight to observations in the more distant past. The reason is that the future is more dependent on the recent past than on the distant past. The method is known to be effective when there is randomness and no seasonal fluctuations in the data. One disadvantage of the method, however, is that it does not include industrial or economic factors such as market conditions, prices, or the effects of competitors’ actions. Model The formula for exponential smoothing is: Yt+1 = Yt + (1 – )Yt

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or in words, Ynew = Yold + (1–)Yold where

Ynew Yold Yold

= exponentially smoothed average to be used as the forecast = most recent actual data = most recent smoothed forecast = smoothing constant

The higher the , the higher weight given to the more recent information. Example 3 Data on sales follow. Time Period(t)

Actual Sales (1,000) (Y)

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

$60.0 64.0 58.0 66.0 70.0 60.0 70.0 74.0 62.0 74.0 68.0 66.0 60.0 66.0 62.0

To initialize the exponential smoothing process, we must have the initial forecast. The first smoothed forecast to be used can be ■ ■

First actual observations An average of the actual data for a few periods

For illustrative purposes, let us use a six-period average as the initial forecast Y7 with a smoothing constant of = 0.40. Then

Y7 = (Y1 + Y2 + Y3 + Y4 + Y5 + Y6)/6 = (60 + 64 + 58 + 66 + 70 + 60)/6 = 63

Note that Y7 = 70. Then Y8 is computed as follows: Y8 = Y7 + (1 – )Y7 = (0.40) (70) + (0.60) (63) = 28.0 + 37.80 = 65.80

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Similary Y9 = Y8 + (1 – )Y8 = (0.40) (74) + (0.60) (65.80) = 29.60 + 39.48 = 69.08

and Y10 = Y9+(1 – )Y9 = (0.40) (62) + (0.60) (69.08) = 24.80 + 41.45 = 66.25

By using the same procedure, the values of Y11, Y12, Y13, Y14, and Y15 can be calculated. Due to the negative and positive differences between actual sales and predicated sales, the forecaster can use a higher or lower smoothing constant , in order to adjust the predication as quickly as possible to large fluctuations in the data series. For example, if the forecast is slow in reacting to increased sales (i.e., if the difference is negative), the user might want to try a higher value. For practical purposes, the optimal may be picked by minimizing what is known as the mean squared error (MSE). MSE = (Yt–Yt )2/(n–i)

where i = the number of observations to determine the initial forecast in the example, i = 6) The next table shows a comparison between the actual sales and predicted sales by the exponential smoothing method. Comparison of Actual Sales and Predicted Sales Time Period (t) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

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Actual Sales (Yt) $60.0 64.0 58.0 66.0 70.0 60.0 70.0 74.0 62.0 74.0 68.0 66.0 60.0 66.0 62.0

Predicted Sales (Yt )

Difference (Yt Yt )

63.00 65.80 69.08 66.25 69.35 68.81 67.69 64.61 65.17

7.00 8.20 7.08 7.75 1.35 2.81 7.69 1.39 3.17

Difference2 (Yt Yt )2

49.00 67.24 50.13 60.06 1.82 7.90 59.14 1.93 10.05 $307.27

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in the example, MSE = 307.27/(15–6) = 307.27/9 = 34.14

The idea is to select the that minimizes MSE, which is the average sum of the variations between the historical sales data and the forecast values for the corresponding periods. Computer and Exponential Smoothing A nonfinancial manager will be confronted with complex problems requiring large sample data and will need to try different values of for exponential smoothing. Virtually all forecasting software has an exponential smoothing routine. Exhibit 15.1 is a sample output from a computer program for exponential smoothing. Notice that the best for this particular example is .9, because it gives the least MSE. Exhibit 15.1 Sample Output from Computer Program PLEASE ENTER THE NUMBER OF OBSERVATIONS ?10 ENTER YOUR DATA NOW THE DATA SHOULD BE SEPARATED BY COMMAS. ?117,120,132,141,140,156,169,171,174,182 ENTER THE NUMBER OF PERIODS OVER WHICH YOU CAN COMPUTE THE AVERAGE TO BE USED AS THE FIRST FORECAST VALUE. ?1 ******* EXPONENTIAL SMOOTHING PROGRAM -SINGLE SMOOTHING ******* PERIOD 1 2

ACTUAL VALUE 117.00 120.00

ESTIMATED VALUE .00 117.00

ERROR

THE VALUE OF THE EXPONENTIAL SMOOTHER IS .1 3 4 5 6 7 8 9 10

132.00 141.00 140.00 156.00 169.00 171.00 174.00 182.00

117.30 118.77 120.99 122.89 126.20 130.48 134.54 138.48

14.70 22.23 19.01 33.11 42.80 40.52 39.46 43.52

THE TOTAL ABSOLUTE ERROR IN ESTIMATE IS 255.34 THE MEAN SQUARED ERROR IS 1136.48 (Continued )

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132.00 141.00 140.00 156.00 169.00 171.00 174.00 182.00

117.60 120.48 124.58 127.67 133.33 140.47 146.57 152.06

14.40 20.52 15.42 28.33 35.67 30.53 27.43 29.94

THE TOTAL ABSOLUTE ERROR IN ESTIMATE IS 202.24 THE MEAN SQUARED ERROR IS 690.23 THE VALUE OF THE EXPONENTIAL SMOOTHER IS .3 3 4 5 6 7 8 9 10

132.00 141.00 140.00 156.00 169.00 171.00 174.00 182.00

117.90 122.13 127.79 131.45 138.82 147.87 154.81 160.57

14.10 18.87 12.21 24.55 30.18 23.13 19.19 21.43


132.00 141.00 140.00 156.00 169.00 171.00 174.00 182.00

118.20 123.72 130.63 134.38 143.03 153.42 160.45 165.87

13.80 17.28 9.37 21.62 25.97 17.58 13.55 16.13


132.00 141.00 140.00 156.00 169.00 171.00 174.00 182.00

118.50 125.25 133.12 136.56 146.28 157.64 164.32 169.16

13.50 15.75 6.88 19.44 22.72 13.36 9.68 12.84

THE TOTAL ABSOLUTE ERROR IN ESTIMATE IS 114.16 THE MEAN SQUARED ERROR IS 226.07

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241


132.00 141.00 140.00 156.00 169.00 171.00 174.00 182.00

118.80 126.72 135.29 138.12 148.85 160.94 166.98 171.19

13.20 14.28 4.71 17.88 20.15 10.06 7.02 10.81


132.00 141.00 140.00 156.00 169.00 171.00 174.00 182.00

119.10 128.13 137.14 139.14 150.94 163.58 168.77 172.43

12.90 12.87 2.86 16.86 18.06 7.42 5.23 9.57


132.00 141.00 140.00 156.00 169.00 171.00 174.00 182.00

119.40 129.48 138.70 139.74 152.75 165.75 169.95 173.19

12.60 11.52 1.30 16.26 16.25 5.25 4.05 8.81


132.00 141.00 ???.?? 156.00 169.00 171.00 174.00 182.00

119.70 133.77 ???.?? 140.00 154.40 167.54 170.65 173.67

12.30 10.23 ??.?? 16.00 14.60 3.46 3.33 8.33

THE TOTAL ABSOLUTE ERROR IN ESTIMATE IS 68.30 THE MEAN SQUARED ERROR IS 102.23 (Continued )

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SUMMARY RESULTS THE EXPONENTIAL THE EXPONENTIAL THE EXPONENTIAL THE EXPONENTIAL THE EXPONENTIAL THE EXPONENTIAL THE EXPONENTIAL THE EXPONENTIAL THE EXPONENTIAL

SMOOTHER SMOOTHER SMOOTHER SMOOTHER SMOOTHER SMOOTHER SMOOTHER SMOOTHER SMOOTHER

.1 .2 .3 .4 .5 .6 .7 .8 .9

WITH WITH WITH WITH WITH WITH WITH WITH WITH

A A A A A A A A A

MEAN MEAN MEAN MEAN MEAN MEAN MEAN MEAN MEAN

SQUARED SQUARED SQUARED SQUARED SQUARED SQUARED SQUARED SQUARED SQUARED

ERROR ERROR ERROR ERROR ERROR ERROR ERROR ERROR ERROR

OF 1138.48 OF 690.23 OF 447.49 OF 308.97 OF 226.07 OF 174.23 OF 140.55 OF 117.91 OF 102.23

Conclusion Various quantitative forecasting methods exist. Native techniques are based solely on previous experience. Smoothing approaches include moving averages and exponential smoothing. Moving averages and exponential smoothing employ a weighted average of past data as the means of deriving the forecast.

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16 Regression Analysis Popular Sales Forecast System

R

egression analysis is a statistical procedure for estimating mathematically the average relationship between the dependent variable and the independent variable(s). Simple regression involves one independent variable, price or advertising in a demand function, whereas multiple regression involves two or more variables, such as price and advertising together. In this chapter, we will discuss simple (linear) regression (i.e., Y = a + bX) to illustrate the least-squares method. Multiple regression is reserved for a forecasting text.

Least- Squares Method The least-squares method is widely used in regression analysis for estimating the parameter values in a regression equation. The regression method includes all the observed data and attempts to find a line of best fit. To find this line, a technique called the least-squares method is used. Exhibit 16.1 shows the regression relationship. To explain the least-squares method, we define the error as the difference between the observed value and the estimated one and denote it with u. Symbolically, u = Y − Y′ where Y = observed value of the dependent variabl Y′= estimated value based on Y′ = a + bX

The least-squares criterion requires that the line of best fit be such that the sum of the squares of the errors (or the vertical distance in Exhibit 16.1 from the observed data points to the line) is a minimum, that is, Minimum: Σu 2 = Σ(Y − a − bX)2

Using differential calculus we obtain these equations, called normal equations: ΣY = na + bΣX ΣXY = aΣX + bΣX 2

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Exhibit 16.1 Y and Y⬘ Y Y' = a + bx

U = Y – Y'

X

Solving the equations for b and a yields b=

nΣXY − (ΣX)(ΣY) nΣX 2 − (ΣX)2

a = Y − bX where Y = ΣX/n and X = ΣX/n

Example 1 To illustrate the computations of b and a, we will refer to the data in Exhibit 16.2. All the sums required are computed and shown in the exhibit. From Exhibit 16.2: ΣX = 174; ΣY = 225; ΣXY = 3, 414; ΣX 2 = 2, 792; ΣY 2 = 4, 359 X = ΣX/n = 174 /12 = 14.5; Y = ΣY/n = 225 /12 = 18.75

Substituting these values into the formula for b first: b=

nΣXY − (ΣX)(ΣY) (12)(3, 414) − (174)(255) 1, 818 = = = 0.5632 nΣX 2 − (ΣX)2 (12)(2, 792) = (174)2 3, 228

a = Y − bX = 18.75 − (0.5632)(14.5) = 18.75 − 8.1664 = 10.5836

Thus, Y⬘ = 10.5836 + 0.5632 X

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Exhibit 16.2 Table for Example 1 Advertising X (000) $

9 19 11 14 23 12 12 22 7 13 15 17 $174

Sales Y (000) $ 15 20 14 16 25 20 20 23 14 22 18 18 $225

XY

X2

Y2

135 380 154 224 575 240 240 506 98 286 270 306 3,414

81 361 121 196 529 144 144 484 49 169 225 289 2,792

225 400 196 256 625 400 400 529 196 484 324 324 4,359

Example 2 Assume that the advertising expense of $10 is to be expended for next year. The projected sales for the year would be computed in this way: Y′ = 10.5836 + 0.5632 X = 10.5836 + 0.5632 (10) = $16.2156

Note that ⌺Y2 is not used here but rather is computed for R-squared (R2).

A Word of Caution Before attempting a least-squares regression approach, it is extremely important to plot the observed data on a diagram, called the scattergraph (see Exhibit 16.3). The reason is to make sure that a linear (straight-line) relationship existed between Y and X in the past sample. If, for any reason, a nonlinear relationship was detected in the sample, the linear relationship we assumed—Y = a + bX—would not give us a good fit. In order to obtain a good fit and achieve a high degree of accuracy, readers should be familiar with statistics relating to regression such as R-squared (R2) and t-value, which are discussed later.

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Exhibit 16.3 Scatter Diagram (000 Omitted) 24 20

Sales (Y)

16 12 8 4 0 4

8

12

16

20 24 Advertising

28

X (000 Omitted)

Regression Statistics Regression analysis is a statistical method. Therefore, it uses a variety of statistics to tell about the accuracy and reliability of the regression results. They include: ■ ■ ■

Correlation coefficient (r) and coefficient of determination (R2) Standard error of the estimate (Se) and prediction confidence interval Standard error of the regression coefficient (Sb) and t-statistic Each of these statistics is explained next.

Correlation Coefficient (r) and Coefficient of Determination (R2) The correlation coefficient r measures the degree of correlation between Y and X. The range of values it takes on is between ⫺1 and +1. More widely used, however, is the coefficient of determination, designated R2. Simply put, R2 tells us how good the estimated regression equation is. In other words, it is a measure of “goodness of fit” in the regression. Therefore, the higher the R2, the more confidence we have in our estimated equation. More specifically, the coefficient of determination represents the proportion of the total variation in Y that is explained by the regression equation. It has the range of values between 0 and 1.

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Example 3 The statement “Sales is a function of advertising expenditure with R2 = 70 percent” can be interpreted as “70 percent of the total variation of sales is explained by the regression equation or the change in advertising, and the remaining 30 percent is accounted for by something other than advertising, such as price and income.” The coefficient of determination is computed as R2 = 1 −

Σ( Y − Y′)2 Σ( Y − Y)2

In a simple regression situation, however, there is a short-cut method available: ⎡ nΣXY − (ΣX)(ΣY)⎤ ⎣⎢ ⎦⎥ ⎡ nΣX 2 − (ΣY)2 ⎤ ⎡ nΣY 2 − (ΣY)2 ⎤ ⎦⎥ ⎣⎢ ⎦⎥ ⎣⎢ 2

R2 =

Comparing this formula with the one for b, we see that the only additional information we need to compute R2 is ⌺Y2. Example 4 To illustrate the computations of various regression statistics, we will refer to the data in Exhibit 16.2. Using the shortcut method for R2, R2 = =

(1.818)2 (3, 228) ⎡⎣⎢(12)(4, 359) − (225)2 ⎤⎦⎥

=

3.305,124 (3, 228)(52, 308 − 50, 625)

3.305,124 3.305,124 = = 0.6084 = 60.84% (3, 228)(1, 683) 5, 432, 724

This means that about 60.84 percent of the total variation in sales is explained by advertising, and the remaining 39.16 percent is still unexplained. A relatively low R2 indicates that there is a lot of room for improvement in our estimated forecasting formula (Y⬘ = $10.5836 + $0.5632X). Price or a combination of advertising and price might improve R2. Standard Error of the Estimate (Se) and Prediction Confidence Interval The standard error of the estimate, designated Se, is defined as the standard deviation of the regression. It is computed as: Se =

Σ(Y − Y′)2 = n−2

ΣY 2 − aΣY − bΣXY n−2

This statistic can be used to gain some idea of the accuracy of our predictions.

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Example 5 Going back to our example data, Se is calculated as: Se = =

4, 359 − (10.5836)(225) − (0.5632)(3.414) 12 − 2 54.9252 = 2.3436 10

Suppose you wish to make a prediction regarding an individual Y value—such as a prediction about the sales when an advertising expense = $10. Usually, we would like to have some objective measure of the confidence we can place in our prediction. One such measure is a confidence (or prediction) interval constructed for Y. A confidence interval for a predicted Y, given a value for X, can be constructed in this manner: Y ′ ± t Se 1 +

1 + n

(X

– X)

2

p

(Σ x)

2

ΣX 2 –

n where Y ′ = the predicted value of Y given a value for X X p = the value of an independent variable used ass the basis for prediction

Note: The critical value for the level of significance employed is t. For example, for a significance level of 0.025 (which is equivalent to a 95 percent confidence level in a two-tailed test), the critical value of t for 10 degrees of freedom is 2.228 (see Table AII.1 in Appendix II). As can be seen, the confidence interval is the linear distance bounded by limits on either side of the prediction. Example 6 To have a 95 percent confidence interval of the prediction, the range for the prediction, given an advertising expense of $10, would be between $10,595.10 and $21,836.10, determined in this way. (Note that from Example 2, Y⬘ = $16.2156.) The confidence interval is therefore established as: $16.2156 ± (2.228)(2.3436) 1 +

1 (10 − 14.5)2 + 2792 − (174) 2/12 12

= $16.2156 ± (2.228)(2.3436)(1.0764) = $16.2156 ± 5.6205

which means the range for the prediction, given an advertising expense of $10, would be between $10.5951 and $21.8361. Note that $10.5951 = $16.2156 ⫺ 5.6205 and $21.8361 = $16.2156 + 5.6205. Standard Error of the Regression Coefficient (Sb) and t-Statistic The standard error of the regression coefficient, designated Sb, and the t-statistic are closely related. Sb is calculated as:

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Sb =

Se Σ(X − X)2

or in short-cut form Sb =

Se Σ(X − X)2

Sb gives an estimate of the range where the true coefficient will actually fall. A definition of t-statistics (or t-value) is that it is a measure of the statistical significance of an independent variable X in explaining the dependent variable Y. It is determined by dividing the estimated regression coefficient b by its standard error Sb. It is then compared with the table t-value. (See Table AII.1 in Appendix II) Thus, the t-statistic measures how many standard errors the coefficient is away from zero. Rule of thumb: Any t-value greater than +2 or less than ⫺2 is acceptable. The higher the t-value, the greater the confidence we have in the coefficient as a predictor. Low t-values are indications of low reliability of the predictive power of that coefficient. Example 7 The Sb for our example is: Sb = = Thus, t-statistic =

2.3436 2,792 − (14.5)(174) 2.3436 2.3436 = = .143 2, 792 − 2, 523 269 b .5632 = 3.94 = .143 Sb

Since t = 3.94 > 2, we conclude that the b coefficient is statistically significant. As was indicated previously, the table’s critical value (cut-off value) for 10 degrees of freedom is 2.228 (from Table AII.1 in Appendix II). Note: ■ ■

The t-statistic is more relevant to multiple regressions that have more than one b. R2 tells how good the forest (overall fit) is while the t-statistic tells how good an individual tree (an independent variable) is.

Note: In summary, the table t value, based on a degree of freedom and a level of significance, is used: ■

■ ■

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To set the prediction range—upper and lower limits—for the predicted value of the dependent variable To set the confidence range for regression coefficients As a cutoff value for the t-test

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Using Regression on Excel Spreadsheet programs such as Excel have an easy-to-use regression routine. To utilize Excel for regression analysis, three steps need to be followed: 1. Click the Tools menu. 2. Click Add-Ins. 3. Click Analysis ToolPak. (If Analysis ToolPak is not listed as an available add-in, exit Excel, double-click the MS Excel setup icon, click Add/Remove, double-click Add-ins, and select Analysis ToolPak. Then restart Excel and repeat the above instruction.) After ensuring that the Analysis ToolPak is available, access the regression tool by completing these three steps: 1. Click the Tools menu. 2. Click Data Analysis. 3. Click Regression. Exhibit 16.4 captures the regression input dialog screen.

Exhibit 16.4 Excel Regression Input Dialog Screen

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Exhibit 16.5 Excel Regression Output SUMMARY OUTPUT Regression Statistics Multiple R R-Squared Adjusted R-Squared Standard Error Observations

0.7800 0.6084 0.5692 2.3436 12

ANOVA

Regression Residual Total

Intercept DLH

df

SS

MS

F

Significance F

1 10 11

85.3243 54.9257 140.25

85.3243 5.4926

15.5345

0.0028

Coefficients

Standard Error

t Stat

P-value*

Lower 95%

Upper 95%

10.583643 0.563197

2.1796 0.1429

0.0007 0.0028

5.7272 0.2448

15.4401 0.8816

4.8558 3.9414

*The P-value for X variable = .0028 indicates that we have a 0.28 percent chance that the true value of the variable coefficient is equal to 0, implying a high level of accuracy about the estimated value of 0.563197.

Exhibit 16.5 shows an Excel regression output that contains the statistics discussed so far. Note: To obtain a scattergraph, use Excel’s Chart Wizard. The result shows: Y′ = 10.5836 + 0.563197 X (in the form of Y′ = a + bX)

with R-squared (R2)= 0.608373 = 60.84% All of the above are the same as the ones manually obtained. Exhibit 16.6 is the regression output from popular statistical software Minitab.

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Exhibit 16.6 Minitab Regression Output Regression Analysis The regression equation is FO = 10.6 + 0.563 DLH Predictor Constant DLH s = 2.344

Coef 10.584 0.5632

Stdev 2.180 0.1429

R-sq = 60.8%

t-ratio 4.86 3.94

p 0.000 0.003

R-sq(adj) = 56.9%

Analysis of Variance SOURCE Regression Error Total

DF 1 10 11

SS 85.324 54.926 140.250

MS 85.324 5.493

F 15.53

p 0.003

Conclusion Regression analysis is the examination of the effect of a change in independent variables on the dependent variable. It is a popularly used method to forecast sales. This chapter discussed a well-known estimation technique, called the leastsquares method. To illustrate the method, we assumed a simple regression, which involves one independent variable in the form of Y = a + bX. In an attempt to obtain a good fit, we discussed various regression statistics. These statistics tell how good and reliable the estimated equation is and help users set the confidence interval for their prediction. Most important, we discussed how to utilize spreadsheet programs such as Excel to perform regressions, step by step. The program calculates not only the regression equation, but also all the regression statistics discussed in this chapter.

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17 Cash Budgeting and Forecasting Cash Flow Two Pragmatic Methods

A

forecast of cash collections and potential write-offs of accounts receivable is essential in cash budgeting and in judging the appropriateness of current credit and discount policies. The critical step in making such a forecast is estimating the cash collection and bad debt percentages to be applied to sales or accounts receivable balances. This chapter discusses two pragmatic methods of estimating cash collection rates (or payment proportions) and illustrates how these rates are used for cash budgeting purposes. The first approach involves a simple average. The second, empirically tested and improved by the author, offers a more pragmatic method of estimating collection and bad debt percentages by relating credit sales and collection data. This method employs regression analysis. By using these approaches, a manager should be able to ■ ■ ■

Estimate future cash collections from customers Establish an allowance for bad debts Provide a valuable insight into better methods of managing accounts receivable

Account Analysis The most straightforward way to estimate collection percentages is to compute the percentages of collections realized from past months. Once the experience has been analyzed, the results can be adjusted for trends and applied to the credit sales portrayed in the sales forecast. An example illustrates the technique.

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Example 1 Assume that an analysis of collection experience for August sales revealed these collection data: Description

% of Total Credit Sales

Collected in August September October November December Cash discounts Bad debt losses Total

2.3 80.2 9.9 5.1 .5 1.0 1.0 100.0

If next year’s sales in August could be expected to fall into the same pattern, then application of the percentages to estimated August credit sales would determine the probable monthly distribution of collections. The same analysis applied to each month of the year would result in a reasonably reliable basis for collection forecasting. The worksheet (August column) for cash collections might look like this: Month of Sale April May June July August Total Collections Cash Discounts (July) Losses Total

% Total

Description Sales Net

August Collection

5 4.2 8.9 82.1 2.3

$168,000 192,000 311,100 325,600 340,000

$840 8,064 27,688 267,318 7,820 $311,730

1.0 1.0

325,600 340,000

(3,256) (3,400) $305,074

Regression Approach A more scientific approach to estimating cash collection percentages (or payment proportions) is to utilize regression analysis. We know that there is typically a time lag between the point of a credit sale and realization of cash. More specifically, the lagged effect of credit sales and cash inflows is distributed over a number of periods in this way: Ct b1St1 b2St2 ..biSti where Ct cash collection in month t St credit sales made in period t b1, b2, . . . bi collection percentages (the same as Pi ) i number of periods lagged

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Cash Budgeting and Forecasting Cash Flow

/

255

By using the regression method discussed in Chapter 16, we will be able to estimate these collection rates. We can utilize Regression of Excel or special regression packages such as SAS, Minitab and SPSS. It should be noted that the cash collection percentages, (b1, b2, … bi) may not add up to 100 percent because of the possibility of bad debts. Once we estimate these percentages by using the regression method, we should be able to compute the bad debt percentage with no difficulty. Exhibit 17.1 shows the regression results using actual monthly data on credit sales and cash inflows for a real company. Equation I can be written: Ct 60.6%(St1) 24.3%(St2) 8.8%(St3) This result indicates that the receivables generated by the credit sales are collected at these rates: first month after sale, 60.6 percent; second month after sale, 24.3 percent; and third month after sale, 8.8 percent. The bad debt percentage is computed as 6.3 percent (100 – 93.7%). It is important to note, however, that these collection and bad debt percentages are probabilistic variables, that is, variables whose values cannot be known with precision. However, the standard error of the regression coefficient and the t-value permit us to assess the probability that the true percentage is between specified limits. The confidence interval takes this form: b t Sb where Sb standard error of the coeffieient

Exhibit 17.1 Regression Results for Cash Collection (Ct) Independent Variables St1 St2 St3

Equation I a

0.606 (0.062)b 0.243a (0.085) 0.088 (0.157)

St4 R2 Standard Error of the estimate (Se) Number of monthly observations Bad debt percentages a b

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0.754 11.63 21 0.063

Equation II 0.596a (0.097) 0.142 (0.120) 0.043 (0.191) 0.136 (0.800) 0.753 16.05 20 0.083

Statistically significant at the 5% significance level. This figure in the parentheses is the standard error of the e estimate for the coefficient (Sb).

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Example 2 To illustrate, assuming t 2 as rule of thumb at the 95 percent confidence level, the true collection percentage from the prior month’s sales will be 60.6% 2(6.2%) 60.6% 12.4% Turning to the estimation of cash collections and allowance for doubtful accounts, these values are used for illustrative purposes: St1 $77.6, St2 $58.5, St3 $76.4, and forecast average monthly net credit sales = $75.2 Then the forecast cash collection for period t would be If the manager wants to be 95 percent confident about this forecast value, then the interval would be set as: Ct tSe where Se = standard error of the estimate To illustrate, using t = 2 as a rule of thumb at the 95 percent confidence level, the true value for cash collections in period t will be $65.04 2(11.63) $65.04 23.26 The estimated allowance for uncollectible accounts for period t will be 6.3% ($75.2) $4.74 By using the limits discussed so far, managers can develop flexible (or probabilistic) cash budgets, where the lower and upper limits can be interpreted as pessimistic and optimistic outcomes. They also can simulate a cash budget in an attempt to determine both the expected change in cash collections for each period and the variation in this value. In preparing a conventional cash inflow budget, the manager considers the various sources of cash, including cash on account, sale of assets, and incurrence of debt. Cash collections from customers are emphasized, since that is the greatest problem in this type of budget. Example 3 These data are given for Erich Stores:

Cash sales Credit sales Total sales

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September Actual

October Actual

November Estimated

December Estimated

$ 7,000 50,000 $57,000

$ 6,000 48,000 $54,000

$ 8,000 62,000 $70,000

$ 6,000 80,000 $86,000

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257

Past experience indicates net collections normally occur in this pattern: ■ ■ ■ ■

No collections are made in the month of sale. 80 percent of the sales of any month are collected in the following month. 19 percent of sales are collected in the second following month. 1 percent of sales are uncollectible. We can project total cash receipts for November and December:

Cash receipts Cash sales Cash collections September sales 50,000 (19%) October sales 48,000 (80%) 48,000 (19%) November sales 62,000 (80%) Total cash receipts

November

December

$ 8,000

$ 6,000

9,500 38,400 9,120

$55,900

49,600 $64,720

Example 4 The manager of John Loyde Co. plans for the company to have a cash balance of $91,000 on March 1. Sales during March are estimated at $900,000. February sales amounted to $600,000 and January sales amounted to $500,000. Cash payments for March have been budgeted at $580,000. Cash collections have been estimated as: ■ ■

■

60 percent of the sales for the month are to be collected during the month. 30 percent of the sales for the preceding month are to be collected during the month. 8 percent of the sales for the second preceding month are to be collected during the month.

The manager plans to accelerate collections by allowing a 2 percent discount for prompt payment. With the discount policy, she expects to collect 70 percent of the current sales and will permit the discount reduction on these collections. Sales of the preceding month will be collected to the extent of 15 percent with no discount allowed, and 10 percent of the sales of the second preceding month will be collected with no discount allowed. This pattern of collection can be expected in subsequent months. During the transitional month of March, collections may run somewhat higher.

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However, the manager prefers to estimate collections on the basis of the new pattern so that the estimates will be somewhat conservative. She has to make two estimates: 1. Estimate cash collections for March and the cash balance at March 31 under the present policy. 2. Estimate cash collections for March and the cash balance at March 31 according to the new policy of allowing discounts. Then she must decide whether the discount policy is desirable. (1) and (2)

Balance, March 1 Collections From March sales From February sales From January sales Total cash available Less disbursements Balance, March 31

Under the Present Policy

Under the Discount Policy

$ 91,000

$ 91,000

540,000 ($900,000 60%) 180,000 ($600,000 30%) 40,000 ($500,000 8%) $851,000 580,000 $271,000

617,400* 90,000 ($600,000 15%) 50,000 ($500,000 10%) $848,400 580,000 $268,400

*$900,000 70% 98% $617,400

The discount policy is not desirable because under it the March 31 cash balance will be smaller, as indicated ($268,400 as compared to $271,000 under the present policy).

Cash Budget The budget preparation process normally begins with the sales budget and continues through the preparation of pro forma financial statements. The last schedule prepared before the financial statements is the cash budget. The cash budget is a schedule of estimated cash collections and payments. The various operating budgets and the capital budget are inputs to the cash budgeting process. The cash budget is prepared for the purpose of cash planning and control. It presents the expected cash inflow and outflow for a designated time period. The cash budget helps management keep cash balances in reasonable relationship to its needs. It aids in avoiding unnecessary idle cash and possible cash shortages. The cash budget presents the amount and timing of the expected cash inflow and outflow for a designated time period. It is a tool for cash planning and control and should be detailed so that managers know how much is needed to run their business. If cash flows can be estimated reliably cash balances can be retained near a target level with fewer transactions.

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/

259

The cash budget should be prepared for the shortest time period for which reliable financial information can be obtained. In the case of many small businesses, this may be one week. However, predicting major cash receipts and cash payments for a specific day is also possible. The cash budget helps management keep cash balances in a reasonable relationship to needs. It aids in avoiding having unnecessary idle cash as well as averting possible cash shortages. If there is idle cash, the excess funds can be invested in short-term securities, such as U.S. Treasury bills and commercial paper, to earn a return; if the budget reveals a cash shortage, money can be borrowed, expenditures cut, or assets sold. The cash budget ensures that users will have sufficient cash funds available to the business at all times. The cash budget also allows for review of future cash receipts and cash payments to uncover possible patterns of cash flows. In this way, collection and disbursement efforts can be studied to ascertain if net cash flows are being maximized. In addition, the cash budget reveals when and how much to borrow and when users will be able to pay the money back. For example, if a cash budget indicates that a significant cash outlay will be needed to buy assets (e.g., store equipment), the user may have to borrow money and determine a debt repayment schedule. In order to obtain a line of credit, lenders typically require borrowers to submit the cash budget along with financial statements. The cash budget typically consists of four major sections: 1. The cash receipts section, which is cash collections from customers and other cash receipts, such as royalty income and investment income 2. The cash disbursements section, which comprises all cash payments made by purpose 3. The cash surplus or deficit section, which simply shows the difference between the total cash available and the total cash needed including a minimum cash balance if required. If there is surplus cash, loans may be repaid or temporary investments made. 4. The financing section, which provides a detailed account of the borrowings, repayments, and interest payments expected during the budgeting period Cash budgets often are prepared monthly, but there are no strict rules for determining the length of the budget period. As a general rule, it should be long enough to show the effect of policies in running the small business, yet short enough so that estimates can be made with reasonable accuracy. Exhibit 17.2 shows the major components of a cash budget. The basis for estimating cash receipts is sales, whether from cash sales or collections from customer balances. An incorrect sales estimate will result in erroneous cash estimates. The sales predictions also influence the projected cash outlays for manufacturing costs, because production is tied to sales. The projection of operating expenses may be tied to the suppliers’ payment terms. Exhibit 17.3 presents a monthly cash budget.

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Exhibit 17.2 Major Cash Flow Components of a Cash Budget Cash Inflows

Cash Outflows

Operating:

Operating:

Cash sales Collections

Nonoperating: Royalties Rents Investments income Sale of marketable securities Loan proceeds

Payroll Inventory purchases Insurance Payments to suppliers Nonoperating: Capital expenditures Interest Loan repayments Tax payments Purchase of marketable securities

Cash Variance Analysis Comparing estimated and actual cash figures allows managers to investigate the reasons for any significant discrepancies and to take any needed corrective action. Variance analysis allows managers to get a better picture of the cash position and provides insight in improving cash estimates in the next budgeting period. It also aids in the periodic revision of projections. This updating typically occurs at the beginning of each budget segment (e.g., the first day of a quarter, assuming a quarterly budgeting period, or the first day of a month, assuming a monthly budgeting period). Budgets should be adjusted immediately for significant changes. Exhibit 17.4 presents an analysis of cash budget variances. Example 5 Exhibit 17.5 is a sample printout of a cash budget generated from Up Your Cash Flow (to be explained later in the chapter).

Cash Flow Software Computer software allows for day-to-day cash management, forecasting and budgeting cash flows, determining cash balances, planning and analyzing cash flows, finding cash shortages, investing cash surpluses, accounting for cash transactions, automating accounts receivable and payable, and dial-up banking. Computerization improves availability, accuracy, timeliness, and monitoring of cash information at minimal cost. Daily cash information aids in planning how

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Ending cash balance (deficiency) before additional borrowings/ (repayments) or (investments) redemptions Bank borrowings/(repayments) (Investments)/redemptions Ending cash balance

Cash disbursements: Material Labor and wages Selling costs General and administrative costs Income taxes Capital equipment Interest expense Total cash disbursements

Beginning of month cash Total available cash

Other cash receipts

Expected Sales Cash receipts: Cash sales Collection from sales: One month ago Two months ago Three months ago Bad debts

$ (97,748)

(117,748) 20,000

145,000 110,000 169,000 49,500 28,500 5,200 16,200 523,400

$ (106,003)

(256,003) 150,000

21,200 17,500 586,700

150,000 169,000 181,000 48,000

(97,748) 330,698

409,945 18,500

259,875 55,350 36,720

58,000

$ 580,000

March

$ (23,408)

(23,408) –

16,900 462,400

125,000 105,000 168,500 47,000

(106,003) 438,993

532,995 12,000

391,500 51,975 29,520

60,000

$ 600,000

April

/

$ (18,988)

(18,988)

28,000 15,000 584,000

138,000 182,000 175,000 46,000

(18,988) 405,653

417,040 7,600

474,013 11,000 80,000 565,013

276,750 68,850 32,940

38,500

$ 385,000

February

344,250 61,763 27,000

$ 410,000

January

75% 15% 8% 2% 100%

$ 510,000

December (actual)

41,000

$ 457,500

November (actual)

10%

$ 375,000

October (actual)

Monthly Cash Budget

Exhibit 17.3

Cash Budgeting and Forecasting Cash Flow 261

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Exhibit 17.4 Cash Budget Variance Analysis Previous Week

Year to Date

Budget

Actual

Budget

Actual

$111,000 $ 2,400 $ 3,000

$109,000 $ 2,500 $ 3,000

$ 990,000 $ 33,000 $ 60,000

$ 979,000 $ 32,500 $ 60,000

$116,400

$114,500

$1,083,000

$1,071,500

Cash disbursements Material purchases Payroll Property taxes Group insurance premium Bank note-interest Lease payment-building Dividend payment Rent

$ 26,300 27,500 5,500 13,000 4,320 5,475 1,232 6,897

$ 18,410 29,000 5,540 13,200 4,320 5,475 1,232 6,897

$ 176,000 400,000 5,500 39,000 15,000 16,425 3,696 20,691

$ 226,000 412,800 5,500 39,600 12,960 16,425 3,696 20,691

Total disbursements Net increase (decrease) in cash

63,924 $ 47,076

65,664 $ 43,336

500,312 $ 489,688

511,672 $ 467,328

Cash receipts Collection from customers Investment income Royalty Total cash receipts

to use cash balances. It enables the integration of different kinds of related cash information, such as collections on customer accounts and cash balances, and the effect of cash payments on cash balances. Spreadsheet program software such as Lotus® 1-2-3, Microsoft’s Excel, and Quattro Pro can assist in developing cash budgets and answering a variety of “what-if” questions. For example, users can see the effect on cash flow from different scenarios (e.g., the purchase and sale of different product lines). There are computer software packages specially designed for cash budgeting and management. For example, Up Your Cash Flow XT (www.upyourcashflow.com/) creates financial forecasts for small to midsize businesses quickly and easily. Accountants and consultants use this powerful software to provide management advice, secure financing, assist troubled businesses and offer other valuable services. Chief financial officers, controllers, and financial managers use Up Your Cash Flow XT to make fast company budgets, manage cash flow, and reach desired levels of profitability. Over 30 reports show the impact of sales, expenses, cost of sales, financing, payroll, inventory, and more—in as much detail as desired. Users can run unlimited “what-if” scenarios to see how changes in business activity affect the bottom line, compare plan to actual data to measure how close they have come to goals, and predict any cash shortfalls before they happen.

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Feb.

Mar.

Apr.

May

Jun.

Jul.

Aug.

Sep.

Oct.

Nov.

Dec.

Total

The assumption used for cash collection is that: 45% of the month’s sales are collected in the month the sale is made. 40% of the sale is collected in the 1st month following the sale. 15% is collected in the 2nd month following the sale—in other words, 45;40;15.

Sales $129,030 $129,030 $129,030 $129,030 $192,610 $192,610 $162,690 $129,030 $192,610 $129,030 $162,690 $192,610 $1,870,000 Previous Months December Previous Years 20,000 10,000 30,000 Collection Current Year Jan. 129,030 45;40;15 58,063 51,612 19,335 129,030 Feb. 129,030 45;40;15 58,063 51,612 19,335 129,030 Mar. 129,030 45;40;15 58,063 51,612 19,335 129,030 Apr. 129,030 45;40;15 58,063 51,612 19,335 129,030 May 192,610 45;40;15 86,675 77,044 28,891 192,610 June 192,610 45;40;15 86,675 77,044 28,891 192,610 July 162,690 45;40;15 73,210 65,076 24,404 162,690 Aug. 129,030 45;40;15 58,063 51,612 19,335 129,030 Sep. 192,610 45;40;15 86,675 77,044 28,891 192,610 Oct. 129,610 45;40;15 58,063 51,612 19,335 129,030 Nov. 162,690 45;40;15 73,210 65,076 138,286 Dec. 192,610 45;40;15 86,674 86,674 Total Collections 78,063 119,675 129,030 129,030 157,642 183,074 179,145 152,030 162,691 154,462 153,713 171,105 1,769,660

Jan.

Your Company, Inc. Cash Collection on the Year

Exhibit 17.5

264 /


A caveat – Perils of spreadsheets Numerous companies rely on spreadsheets to develop complex financial models, organize financial reporting, and analyze data, not to mention budgeting. Note, however, according to the University of Hawaii, between 78 and 97 per cent of spreadsheets contain “serious material errors” with a potential to devastate the bottom line. 1. A number misrecorded in just one cell of a spreadsheet meant one company had to reduce drastically its fourth quarter outlook. Its shares lost more than 25 per cent of their value. 2. A cut-and-paste error led to another company underbidding for an electricity supply contract. 3. A missing minus sign caused a fund’s projected earnings to be overstated by $2.6 billions. 4. Falsely linked spreadsheets covered up a fraud totaling $700 millions at one bank. 5. A faulty macro delayed the introduction of a drug, savaging a pharmaceutical company’s profits. 6. A wrongly named spreadsheet led to the inflation of natural gas prices in the U.S. when one company submitted erroneous gas storage figures. Here are some suggestions that can prevent costly spreadsheet errors. ■

■

■

Companies need to conduct an inventory of all spreadsheets to identify which are critical and where problems might arise. At a bare minimum, those developing spreadsheets should design them meticulously, and once they are completed should test them using known results according to a written plan, test them again using a commercial auditing tool and then attack them for a third time by inviting peers or a trusted security adviser to examine them. Information Technology (IT) department should be responsible for spreadsheets so that experts can bring them under the same development, testing and control procedures as other computer applications.

Conclusion Two methods of estimating the expected collectible and uncollectible patterns of customer accounts were presented. The regression approach is relatively inexpensive to use because all it requires is data on cash collections and credit sales. Furthermore, credit sales values are all predetermined. Because previous months’ credit sales are used to forecast cash collections, there is no need to forecast credit sales. The model allows users to make all kinds of statistical inferences about the cash collection percentages and forecast values. The chapter also illustrated how collection rates are used for cash budgeting purposes and how the cash budget is constructed.

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18 Financial Modeling Tools for Budgeting and Profit Planning

M ■ ■ ■ ■ ■

any companies are increasingly using financial modeling to develop their budgets. This chapter discusses:

What is a financial model? What are some typical uses of financial models? What are the types of financial modeling? How widespread is the use of financial modeling in practice? How do we go about building a financial model?

Chapter 19 describes the use of spreadsheets and financial modeling languages for financial modeling.

A Financial Model A financial model, narrowly called a budgeting model, is a system of mathematical equations, logic, and data that describes the relationships among financial and operating variables. A financial model can be viewed as a subset of broadly defined corporate planning models or a stand-alone functional system that attempts to answer a certain financial planning problem. A financial model is one in which: ■

■

One or more financial variables appears (expenses, revenues, investment, cash flow, taxes, and earnings). The model user can manipulate (set and alter) the value of one or more financial variables. 265

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The purpose of the model is to influence strategic decisions by revealing to the decision maker the implications of alternative values of these financial variables.

Exhibit 18.1 shows a flowchart of a simplified financial planning model. Financial models fall into two types: simulation, better known as “what-if” models, and optimization models. “What-if” models attempt to simulate the effects of alternative management policies and assumptions about the firm’s external environment. They are basically a tool for management’s laboratory. Optimization models are ones in which the goal is to maximize or minimize an objective such as present value of profit or cost. Experiments are being made on multiobjective techniques, such as goal programming. Models can be deterministic or probabilistic. Deterministic models do not include any random or probabilistic variables, whereas probabilistic models incorporate random numbers and/or one or more probability distributions for variables such as sales and costs. Financial models can be solved and manipulated computationally to derive from them the current and projected future implications and consequences. Due to technological advances in computers (i.e., spreadsheets, financial modeling languages, graphics, database management systems, and networking), more companies are using modeling.

Budgeting and Financial Modeling Basically, a financial model is used to build a comprehensive budget (i.e., projected financial statements, such as the income statement, balance sheet, and cash flow statement). Such a model can be called a budgeting model, since we are essentially developing a master budget with it. Applications and uses of the model, however, go beyond developing a budget. They include: ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■

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Financial forecasting and analysis Capital expenditure analysis Tax planning Exchange rate analysis Analysis for mergers and acquisitions Labor contract negotiations Capacity planning Cost-volume-profit analysis New venture analysis Lease/purchase evaluation Appraisal of performance by segments Market analysis New product analysis

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Financial Modeling / 267

Exhibit 18.1 Flowchart of a Simplified Financial Planning Model Sales Estimates

Operating Income

Asset Requirements Investment Needs

Financing* Needs

Net Income Before Taxes

DebtEquity Financing Mix Debt** Financing

Equity Financing

Internal/ External Equity Financing Mix

Interest Expense Income Tax

Internal Equity Financing

External Equity Financing

Total Equity Dollars and Shares

Earnings Per Share

Net Income

Common Dividends

Share Price

Feedback Relationship ** Ignoring underwriting expense

Valuation Process

Investors’ Preference

Source: Thomas Naylor, ed., Simulation in Business Planning and Decision Making (La Jolla, CA: Society for Computer Simulation, 1981), p. 91.

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268 / ■ ■ ■ ■ ■


Development of long-term strategy Planning financial requirements Risk analysis Cash flow analysis Cost and price projections

Use of Financial Modeling in Practice The use of financial modeling, especially a computer-based financial modeling system, is in wide use. The simple reason is the growing need for improved and quicker support as a management decision support system (DSS) and wide and easy availability of computer hardware and software. Some of the functions currently served by financial models, as described by the users, are: ■

■

■

■

■

■

■ ■ ■

■ ■

■

■ ■

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Projecting financial results under any given set of assumptions, evaluating the financial impact of various assumptions and alternative strategies, and preparing long-range forecasts Computing income, cash flow, and ratios for five years by months, as well as energy sales, revenue, power generation requirements, operating and manufacturing expenses, manual or automatic financing, and rate structure analysis Providing answers and insights into financial “what-if” questions and providing scheduling information, such as production planning Forecasting the balance sheet and income statement with emphasis on alternatives for the investment securities portfolio Projecting operating results and various financing needs, such as plant and property levels and financing requirements Computing manufacturing profit, any desired processing sequence through the manufacturing facilities, and simulating effect on profits of inventory policies Generating profitability reports of various responsibility centers Projecting financial implications of capital investment programs Showing the effect of various volume and activity levels on budget and cash flow Forecasting corporate sales, costs, and income by division and by month Providing sales revenue for budget, a basis for evaluating actual sales department performance, and other statistical comparisons Determining pro forma cash flow for alternative development plans for real estate projects Analyzing the impact of an acquisition on company earnings Determining economic attractiveness of new ventures, such as products, facilities, and acquisitions

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Financial Modeling / 269 ■ ■ ■ ■

Evaluating alternatives of leasing or buying computer equipment Determining corporate taxes as a function of changes in price Evaluating investments in additional capacity at each major refinery Generating income statements, cash flow, present value, and discounted rate of return for potential mining ventures, based on production and sales forecasts

Supported by the expanded capabilities provided by models, many companies are increasingly successful in including long-term strategic considerations in their business plans, thus enabling them to investigate the possible impact of current decisions on the long-term welfare of the organization.

Developing Financial Models Development of financial models essentially involves definition of variables, input parameter values, and model specification. As far as model specification goes, we will concentrate only on the simulation-type model specification in this section. Generally speaking, the model consists of three important ingredients: 1. Variables 2. Input parameter values 3. Definitional and/or functional relationships

Definition of Variables Fundamental to the specification of a financial model is the definition of the variables to be included. Basically, the three types of variables are policy variables (Z), external variables (X), and performance variables (Y). Policy variables (often called control variables) are those over which management can exert some degree of control. Examples of financial variables are cash management, working capital, debt management, depreciation, tax, mergeracquisition decisions, the rate and direction of the firm’s capital investment programs, the extent of its equity and external debt financing and the financial leverage represented thereby, and the size of its cash balances and liquid asset position. Policy variables are denoted by the symbol Z in Exhibit 18.2. External variables are the environmental variables that are external to the company and that influence the firm’s decisions from outside. Generally speaking, the firm is embedded in an industry environment. This environment, in turn, is influenced by overall general business conditions. General business conditions exert influences on particular industries in several ways. Total volume of demand, product prices, labor costs, material costs, money rates, and general expectations are among the industry variables affected by the general business conditions. The symbol X represents the external variables in Exhibit 18.2.

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Exhibit 18.2 Flowchart of Variables in a Corporate Model Z Policy Variables

X External Variables

Corporate Planning Model

Y Performance Variables

Performance variables, which measure the firm’s economic and financial performance, usually are produced internally. We use the symbol Y in the exhibit. The Y’s often are called output variables. The output variables of a financial model would be the line items of the balance sheet, cash budget, income statement, or statement of cash flows. How the output variables of the firm are defined will depend on the goals and objectives of management. They basically indicate how management measures the performance of the organization or some segments of it. Management is likely to be concerned with the firm’s level of earnings, growth in earnings, projected earnings, growth in sales, and cash flow. Frequently, when we attempt to set up a financial model, we face risk or uncertainty associated with particular projections. In a case such as this, we treat some of these variables, such as sales, as random variables with given probability distributions. The inclusion of random variables in the model transforms it from a deterministic model to a risk analysis model. However, the use of the risk analysis model in practice is rare because of the difficulty involved in modeling and computation. Input Parameter Values The model includes various input parameter values. For example, in order to generate the balance sheet, the model needs to input beginning balances of various asset, liability, and equity accounts. These input and parameter values are supplied by management. The ratio between accounts receivable and financial decision variables, such as the maximum desired debt-equity ratio, would be good examples of parameters.

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Financial Modeling / 271

Model Specification Once we define various variables and input parameters for our financial model, we must then specify a set of mathematical and logical relationships linking the input variables to the performance variables. The relationships usually involve either definitional equations or behavioral equations. Definitional equations take the form of accounting identities. Behavioral equations involve theories or hypotheses about the behavior of certain economic and financial events. They must be tested and validated before they are incorporated into the financial model. Definitional Equations Definitional equations are exactly what the term implies—mathematical or accounting definitions. For example: Assets Liabilities Equity Net Income Revenues Expenses

These definitional equations are fundamental definitions in accounting for the balance sheet and income statement, respectively. Another example is: CASH CASH(1) CC OCR DEBT CD LP

This equation is a typical cash equation in a financial model. It states that ending cash balance (CASH) is equal to the beginning cash balance (CASH(1)) plus cash collections from customers (CC) plus other cash receipts (OCR) plus borrowings (DEBT) minus cash disbursements (CD) minus loan payments (LP). Another example is: INV INV(1) MAT DL MO CGS

This equation states that ending inventory (INV) is equal to the beginning inventory (INV(1)) plus cost of materials used (MAT) plus cost of direct labor (DL) plus manufacturing overhead (MO) minus the cost of goods sold (CGS). Behavioral Equations Behavioral equations describe the behavior of the firm regarding the specific activities that are subject to testing and validation. The classical demand function in economics is: Q f (P) or more specifically Q a bP

It simply says that the quantity demanded is negatively related to the price. That is to say, the higher the price, the lower the demand. However, the firm’s sales are more realistically described in this way: SALES f (P, ADV., I, GNP, Pc, etc.)

or,

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assuming linear relationship among these variables, we can specify the model as: SALES a bP cADV dI eGNP fPc

which says that the sales are affected by such factors as price (P), advertising expenditures (ADV), consumer income (I), gross national product (GNP), and prices of competitive goods (Pc). With the data on SALES, P, ADV, I, GNP, and Pc, we will be able to estimate parameter values a, b, c, d, e, and f, using linear regression. We can test the statistical significance of each of the parameter estimates and evaluate the overall explanatory power of the model, measured by the t-statistic and R-squared, respectively. This way we will be able to identify the most influential factors that affect the sales of a particular product. With the best model chosen, management can simulate the effects on sales of alternative pricing and advertising strategies. We can also experiment with alternative assumptions regarding the external economic factors such as GNP, consumer income, and prices of competitive goods. Model Structure A majority of financial models that have been in use are recursive and/or simultaneious models. Recursive models are the ones in which each equation can be solved one at a time by substituting the solution values of the preceding equations into the right hand side of each equation. An example of a recursive model is: (1) SALES A B*PRICE + C*ADV (2) REVENUE SALES*PRICE (3) CGS .70*REVENUE (4) GM SALES CGS (5) OE ~10,000 .2*SALES (6) EBT GM OE (7) TAX .46*EBT (8) EAT EBT TAX

In this example, the selling price (PRICE) and advertising expenses (ADV) are given. A, B, and C are parameters to be estimated and SALES sales volume in units REVENUE sales revenue CGS cost of goods sold GM gross margin OE operating expenses EBT earnings before taxes TAX income taxes EAT earnings after taxes

Simultaneous models frequently are found in econometric models that require a higher level of computational methods, such as matrix inversion. An example of a simultaneous model is:

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Financial Modeling / 273 (1) INT .10*DEBT (2) EARN REVENUE CGS OE INT TAX DIV (3) DEBT = DEBT(1) BOW (4) CASH = CASH(1) CC BOW EARN CD LP (5) BOW = MBAL CASH

Note that earnings (EARN) in equation (2) is defined as sales revenue minus CGS, OE, interest expense (INT), TAX, and dividend payment (DIV). But INT is a percentage interest rate on total debt in equation (1). Total debt in equation (3) is equal to the previous period’s debt (DEBT(1)) plus new borrowings (BOW). New debt is the difference between a minimum cash balance (MBAL) minus cash. Finally, the ending cash balance in equation (5) is defined as the sum of the beginning balance (CASH(1)), cash collection, new borrowings and earnings minus cash disbursements and loan payments of the existing debt (LP). Even though the model presented here is a simple variety, it is still simultaneous in nature, which requires the use of a method capable of solving simultaneous equations. Very few of the financial modeling languages have the capability to solve this kind of system. Decision Rules In addition to definitional equations and behavioral equations, the financial model may include basic decision rules specified in a very general form. The decision rules are not written in the form of conventional equations. They are described algebraically using conditional operators, consisting of statements of the type: “IF . . . THEN . . . ELSE.” For example, suppose that we wish to express this decision rule: “If X is greater than 0, then Y is set equal to X multiplied by 5. Otherwise, Y is set equal to 0.” Then we can express the rule in this way: Y IF X GT 0 THEN X*5 ELSE 0

Suppose the company wishes to develop a financing decision problem based on alternative sales scenarios. To determine an optimal financing alternative, managers might want to incorporate some decision rules into the model for a “what-if” or sensitivity analysis. Some examples of these decision rules are: ■

■

■

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The amount of dividends paid is determined on the basis of targeted earnings available to common stockholders and a maximum dividend payout ratio specified by management. After calculating the external funds needed to meet changes in assets as a result of increased sales, dividends, and maturing debt, the amount of long-term debt to be floated is selected on the basis of a prespecified leverage ratio. The amount of equity financing to be raised is chosen on the basis of funds needed that are not financed by new long-term debt, but is constrained by the responsibility to meet minimum dividend payments.

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In the model we have just described, simultaneity is quite evident. A sales figure is used to generate earnings, and this in turn leads to, among other items, the level of long-term debt required. Yet the level of debt affects the interest expense incurred within the current period and, therefore, earnings. Furthermore, as earnings are affected, so are the price at which new shares are issued, the number of shares to be sold, and earnings per share. Earnings per share then feed back into the stock price calculation. Lagged Model Structure Lagged model structure is common in financial modeling. Virtually all balance sheet equations or identities are of this type. For example: Capital capital(1) net income contributions cash dividends

More interestingly, CC a*SALES + b*SALES(1) C*SALES(2) where CC cash collections from customers a percent received in the month of sale b percent received in the month of following sale c percent received in the second month following sale

This indicates that the realization of cash lags behind credit sales. Figure 18.3 illustrates a sample financial (budgeting) model.

Exhibit 18.3 Comprehensive Financial Model Corporate Financial Model Balance Sheet Equations Casht Casht1 Cash receiptst Cash disbursementst Accounts receivablet (1 a) Sales (1 b a) Salest1 (1 c b a) Salest2 Inventoryt Inventoryt1 Inventory purchaset

(

Salest Variable cost per unit _______________ Selling price per unit

)

Plant Initial Value Accounts payablet (m) Variable selling/administrative expensest1 (n) Variable selling/administrative expensest Inventiry purchaset Fixed expensest Bank loant Bank loant Loant Loan repaymentt Common stock Initial value Retained earningst Retained earningst1 Net incomet

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Exhibit 18.3 (Continued ) Income Statement and Cash Flow Equations Cash receiptst (a) Salest (b) Salest–1 (c) Salest–2 Loant Cash disbursementst Accounts payablet–1 Interestt Loan repaymentst Inventory purchaset [0] Variable cost per unit

(

Salest Salest–1 Salest–2 Salest–3 __________________________ – Inventoryt–1 Selling price per unit

)

Interestt (i) Bank loant

(

Variable cost per unit Variable cost of salest Salest _______________ Selling price per unit

)

Variable sellingt administrative expensest (x) Salest Net income before taxest Salest Interestt Variable cost of salest Variable selling/administrative expensest Fixed expensest – Depreciationt Tax expenset (0) (r) Net income before taxest Net incomet Net income before taxest Tax expenset Input Variables (Dollars) Salest1, t2, t3 Loant Loan repaymentt Fixed expenset Depreciationt Selling price per unit Variable cost per unit Input Parameters Accounts receivable collection patterns a—Percent received within current period b—Percent received with one-period lag c—Percent received with two-period lag abc

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